How to hedge a large illiquid position?

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JohnThainsLimoDriver

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Suppose you own a large position (relative to your net worth) of an illiquid stock that for whatever reason you can't sell. How do you hedge it? Assume:

-no listed options on the stock
-can't box your trade in (ie. can't short the stock against your own position)
-your position is not large enough to be able to do a swap or OTC option transaction with a bank
-you want to minimize basis risk, so if you own a small cap biotech it doesn't make much sense to short the SPY, a biotech ETF, or a basket of large caps like Amgen, Biogen, etc.



Edited 1 time(s). Last edit at Saturday, June 13, 2009 at 12:35AM by JohnThainsLimoDriver.
 
What about long puts on the most closely related stock(s)? You still have basis risk, but you remove the downside risk associated with shorting the basket or ETF.

It's imperferct, but for the most part you cover yourself against a large drop in the sector.

Is this some sort of family closely held investment? In LIII, I read about this vehicle that pools the closely held interests of many owners' and executives' companies. Everyone gets shares of the pool (like mutual fund).
 
Yeah that was my idea, but I was told these pooled investment vehicles usually require a minimum of $10 million per contributor and this position would be only around $1 million.
 
Still too much basis risk, and if you assume the stock is something like a small biotech company, chances are the most similar companies won't have options contracts available either.
 
That's right. I think my theory works fairly well for materials and industrials - for those ypes of companies, firm price movements are more attributable to sector movements.
 
^Meaning that the underlying asset and your hedgeing instrutment doesn't move in lock steps.
 
Depends on what the large asset is, what is its main business? Does it depend on an input such as oil, if business is better when oil is down you could hedge with futures. If it is a house again could use futures, or are those being lumped in with options?

Likely any business has input costs that you could short/ go long to help hedge.
 
hausm49008 Wrote:
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> pair trade, short their competition

He wants to minimize basis risk.
 
If you want to minimize basis risk why don't you determine what the delta of your hedging position is?
 
If the stock is shortable just do a swap with a private investor. Get a lawyer to handle the details and security.
 
quote:

"-your position is not large enough to be able to do a swap or OTC option transaction with a bank "
 
Dunno, start making a market in options for the stock, haha? Otherwise I think you are going to have basis risk, unless you can get in an exchange fund, do something OTC or short the stock...hmmm, let me know what you find, good finance brainteaser.
 
RTQ! quote: "with a bank"

$1 million is enough to efficiently do a swap with another private investor if the stock is shortable.
 
Actually delta is probably not the correct terminology - you need to regress the returns between your underlying and the security you'll use as a hedge, thus you can determine the beta to minimize basis risk.
 
joemontana Wrote:
-------------------------------------------------------
> What about long puts on the most closely related
> stock(s)? You still have basis risk, but you
> remove the downside risk associated with shorting
> the basket or ETF.
>
> It's imperferct, but for the most part you cover
> yourself against a large drop in the sector.
>

You could also buy puts in a stock with a correlation of 1 or buy stock with a correlation of -1.
 
KJH Wrote:
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> RTQ! quote: "with a bank"
>
> $1 million is enough to efficiently do a swap with
> another private investor if the stock is
> shortable.


Maybe, but can you say "counterparty risk"
 
A decent lawyer should be able to draw up an agreement that limits your counterparty risk. There's no free lunch... you want out but you can't sell so you have to pay up and take some risk. This is by far the best way discussed so far.
 
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