Performance of Thinly Traded Assets: A Case in Real Estate

Published date01 August 2013
Date01 August 2013
The Financial Review 48 (2013) 511–536
Performance of Thinly Traded Assets:
A Case in Real Estate
Ping Cheng
Florida Atlantic University
Zhenguo Lin
California State University, Fullerton
Yingchun Liu
Laval University
Thinly traded private assets do not fit into the traditional financeparadigm of a liquid and
well-functioning market where trading is continuous and instantaneous. Since private assets
cannot be bought and sold easily, they bear liquidity risk. Classical finance theories cannot
properly gauge the performance of illiquid private assets because they implicitly assume such
illiquidity is trivial. This paper proposes an alternative performance metric for the illiquid
private asset, which explicitly captures liquidity risk in a formal analysis. Applying the new
performance metric, we are able to explain the decades-old “real estate risk premium puzzle.”
Keywords: liquidity risk, private assets, investment performance
JEL Classifications: G11, G12
Corresponding author: Department of Finance, Mihaylo College of Business and Economics, Califor-
nia State University, Fullerton, CA 92834-6848; Phone: (657) 278-7929; Fax: (657) 278-2161; E-mail:
C2013, The Eastern Finance Association 511
512 P.Cheng et al./ The FinancialReview 48 (2013) 511–536
1. Introduction
Classical finance theory defines the market portfolio as one that includes all
assets—publically traded securities, as well as privately traded nonsecurity assets.
Advancement in the finance field, however, primarily has been concentrated on the
public side of the portfolio, namely the relatively efficient security market. Signifi-
cantly less attention has been paid to the private side that includes variousnonsecurity
assets (e.g., private business ownership, partnership interest, hedge-fund holdings,
capital goods, nonstandard loans, artwork, real estate, etc.) that are infrequently
traded in decentralized, incomplete, and inefficient markets. Due to their heterogene-
ity, indivisibility, immobility, and information opacity, among other things, private
assets typically cannot be instantly bought and sold at any time an investor desires. So
the potential loss of welfare due to such an inability to trade out of a position when
needed is a significant source of liquidity risk. Theories developed for publically
traded security assets provide limited guidance for gauging the performance of thinly
traded private assets due to the significant differencesbetween the two types of assets
and their respective markets. We propose an alternative performance measure for
private assets, by which such liquidity risk is explicitly captured in a formal analysis.
Much finance research has dealt with the illiquidity (or the lack of liquidity) of
security assets from various points of view, but relatively few studies have focused
on the illiquidity of the private market and nonsecurity assets. So it is necessary to
note that the concept of illiquidity in the private market differs from the illiquidity
of publically traded security assets. Generally speaking, the research accepts two
definitions of illiquidity. In the securities market where trading is instantaneous
among market participants, liquidity is typically measured by the price discount
(e.g., the bid-ask spread) necessary for an immediate sale (Demsetz, 1968; Amihud
and Mendelson, 1986). Alternative liquidity measures proposed by later studies such
as Brenan and Subrahmanyam (1996) and Amihud (2002) also are for the security
assets. On the other hand, in thinly traded private markets where infrequent trading
is conducted through a lengthy search process, liquidity is measured by the expected
time necessary to sell an asset near its fair market value, the so-called “time-on-
market” (TOM) (Lippman and McCall, 1986). These two measures, though somewhat
related, are fundamentally different due to their difference in underlying transaction
processes and normal trading behaviors. For example, while it is rational to accept
a discounted price for the immediate sale of stocks, the instant sale of a piece of
real estate (as in the case of imminent foreclosure) would characterize the behavior
of an extremely distressed seller. While the likely (deep) price discount reflects the
degree of distress of the seller, it does not properly reflect the illiquidity of the real
asset under normal situations. Put differently, since normal real estate sellers do not
attempt immediate sales, the price discount that would be necessary for such an
immediate sale is not an appropriate measure of the asset’s illiquidity. This leads
us to Lippman and McCall’s (1986) liquidity definition—the expected time until an
asset is successfully exchanged for cash under optimal policies. As has been widely

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