explaindifferencesinstockreturns,donotactasproxiesfor
illiquidity.
Insummary,both thetheoreticalmodelsand theempirical
results suggest that we should adjust discount rates for
illiquidity,withtheformerfocusingonsystematicliquidityas
thekey factorand thelatterusing proxiessuch asbid-ask
spreads and turnover ratios to measure liquidity. Both
approachesalsoseemtoindicatethattheadjustmentwillvary
acrosstimeandwillbedependentonamarketwidedemand
for liquidity. Thus, for any given level of illiquidity, the
expectedpremium addedonto discountrateswillbe much
greaterinperiodswhenthemarketvaluesliquiditymoreand
smaller in periods when it values it less.
Illiquidity as an Option
Whatisthevalueofliquidity?Putdifferently,whendoesan
investorfeelthelossofliquiditymoststronglywhenholding
anasset?Therearesomewhowouldarguethatthevalueof
liquidityliesinbeingabletosellan assetwhenitismost
overpriced;thecostofilliquidityisnotbeingabletodothis.
In the special case where the owner of an asset has the
capacitytoevaluatewhenthisoverpricingoccurs,thevalue
of illiquidity can be considered an option.
Longstaff(1995)presentsanupperboundfortheoptionby
consideringan investorwithperfect markettiming abilities
whoownsanassetonwhichsheisnotallowedtotradefora
period(t).Intheabsenceoftradingrestrictions,thisinvestor
wouldsellatthemaximumpricethatanassetreachesduring
the time period, and the value of the look-back option