Liquidation cost: why mark-to-market values are wrong

Equity portfolios are marked-to-market on the assumption that each share will recoup that amount of cash – but exiting large positions has a market impact, wiping out value. New research indicates this dynamic may be governed by a universal law. Laurie Carver reports

It is the kind of story old traders tell around the campfire: it starts with a big, long position in a stock, the price of which starts to slide. The trader’s reaction is to sell, and sell in size, but the market is spooked and the depreciation only accelerates. The trader is desperate to exit, selling more stock – and the price drops again – and this continues until the bottom, or bankruptcy, is reached.

The phenomenon is as old as markets themselves. According to one near-contemporary – though unscientific – account of the bursting of the Dutch tulip bubble, trading was abandoned on the Haarlem tulip exchange on February 4, 1637 when investors looking to unload their inventory forced prices on successive trades to drop by 15%, then a further 25%, then 35%. It is not hard to draw parallels with the sudden evaporation of value in subprime mortgage-backed assets in 2007, as banks vainly sought buyers. These are extreme examples of an everyday effect – market impact, or an asset’s price movement due to order flows.

Practitioners have long known about this – and the consequent discrepancy between the mark-to-market value and the actual value that can be achieved during liquidation – but until now there has not been a convincing quantitative way to get hold of it. Indeed, finance theory tended to ignore the problem by assuming perfectly liquid, efficient, frictionless markets.

But new analysis by so-called econophysicists is shedding light on what is now being called liquidation value, and some believe the work could have profound consequences. “The new thing is that liquidity cost is very important to risk,” says Doyne Farmer, a professor at the Sante Fe Institute in New Mexico. “If regulators had valued the accounts of Lehman Brothers taking account of liquidity they would have seen their real level of leverage. The crisis might have been avoided,” he says.

The research also suggests mark-to-market values are significantly too high – it might reflect where the market is trading, but because there will be a market impact on liquidation, it does not reflect the actual realisable value of the position. For cash equities, the extent of the overvaluation for a large position in a single stock is likely to be measured in the low single digits, research suggests. Quants that have attempted to carry the same technique across to over-the-counter derivatives markets say the value of big, illiquid instruments could be overstated by as much as 20%.

Work on liquidation value has been stimulated in part by improved access to data. “It started in the early 2000s,” says Fabrizio Lillo, a colleague of Farmer at the Santa Fe Institute and a professor at Scuola Normale, a university in Pisa. “By looking at the data from several markets, we could get a better sense of the order book, and a greater indication of how the price changes.” And the empirical evidence tells a story that is not the sort of thing you are supposed to find in economics – hard rules.

“What’s really intriguing is it seems to be a fundamental law,” says Jean-Phillipe Bouchaud, chairman and head of research at Paris-based hedge fund Capital Fund Management and a professor at École Polytechnique, also in Paris. “Some very illiquid markets may be a bit different – but we have a wide array of the more transparent markets all showing the same behaviour. The relationship seems quite robust, and may just be a fact of the way markets work.”

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