Option on Liquidity

Barry A. Goss and Joost M.E. Pennings*

PURPOSE:

The universal desire by investors to economize on transactions costs has been heightened by the increased cost of liquidity, which has accompanied recent market turmoil. This proposal for an "Option on Liquidity" addresses the situation where an investor wishes to make a transaction of a given size at a specific future date, but is concerned that the liquidity cost of the transaction may be prohibitive, or at least, is uncertain. The "Option on Liquidity" allows the investor to ensure that the cost of liquidity does not exceed a pre-determined maximum, and in some circumstances, the investor may wish to lock in a given cost of liquidity.

PRODUCT:

The Option on Liquidity can take the form of a Call Option or a Put Option. The Proposal is illustrated by the example of an option on futures, but the concept is applicable to cases where the underlying is a spot asset or another option contract.

POTENTIAL USERS:

It is anticipated that the demand for an Option on Liquidity would come from a range of investors for whom liquidity costs are critical. These include:

• Day traders, whose profits are driven by large volumes and small price spreads.
• Hedgers, for whom liquidity risk is an important component of the overall risk of their futures and spot market positions.
• Large investors, such as hedge funds and private equity funds, who are concerned that their large transactions could move the cost of liquidity against them.
• Speculators, who may have expectations about the size and magnitude of changes in liquidity in a particular market.

It is anticipated that dealers, who benefit from an increase in the cost of liquidity, will write Options on Liquidity.

ADVANTAGES:

• Reduced uncertainty to the buyer of the option, who knows that the cost of liquidity will not exceed a pre-determined maximum.
• The writer knows that she will receive the market cost of liquidity plus option premium (if not exercised), or strike price plus option premium (if exercised). The second transaction might have been lost in the absence of this instrument.
• To the exchange: the likely increase in volume is expected to reduce liquiditycosts due to "increasing returns" to liquidity.

* B.A. Goss is Director, Futures Markets Research Associates Pty Ltd, Melbourne, Australia, email Barry.Goss@fmra.com.au (previously Reader in Economics, Monash University, Australia).

 J.M.E. Pennings is Professor of Finance and Marketing, University of Maastricht, and Chairman, FS-Innovators, Maastricht, The Netherlands, email pennings@fs-innovators.com