Explain how a fund can handle and model redemption risk, covering the redemption waterfall, modeling of redemption-at-risk, and tuning liquidity so that withdrawals can be met.
The idea
Redemption risk is handled by deciding in advance how redemptions will be funded and how large they could be. A redemption waterfall is the pre-set order of sources: cash and near-cash first, then highly liquid assets, then less liquid assets or credit lines. Paying from the most liquid assets first protects cost but leaves the remaining portfolio less liquid. Selling a vertical slice keeps the mix unchanged. Redemption-at-risk (RaR) is the net redemption over a horizon not expected to be exceeded at a chosen confidence level. With z the normal quantile for the chosen confidence level and normal flows, RaR = mean + z × standard deviation. Over T periods the mean scales with T and the standard deviation with the square root of T. Tuning liquidity means holding enough cash and liquid assets, after stress haircuts, to cover RaR. The usual mistake is ignoring the mean or scaling volatility linearly.
Formulas
Redemption-at-risk over T periods with normal flows
RaR = μ × T + z × σ × √T
- μ
- the mean net redemption per period
- T
- the number of periods
- z
- the normal quantile for the confidence level
- σ
- the standard deviation of net redemptions per period
Assumes independent, identically distributed normal flows. Ignoring the mean or scaling σ linearly with T are the usual mistakes.
A practice question
In a redemption waterfall, a fund meets redemption requests by:
- drawing on cash sources in a set order, from most to least liquid - correct
- selling a proportional slice of every holding so the portfolio mix stays unchangedWhy not: Describes a vertical-slice approach, the alternative to a waterfall, which keeps the mix unchanged.
- paying all redeemers in securities on the first dealing dayWhy not: Describes redemption in kind, which is a separate emergency tool.
- lowering the dealing price for redeemers by the cost of selling the assetsWhy not: Describes swing pricing, an anti-dilution measure and not an ordering of liquidity sources.
A waterfall ranks funding sources: cash and near-cash first, then liquid securities, then less liquid assets or facilities. The order is fixed ahead of time so that redemptions are met at the lowest expected cost.
A harder one
Weekly net redemptions for a fund with NAV of USD 800 million are approximately normal with a mean of 2% of NAV and a standard deviation of 3% of NAV. The one-week 95% (one-tailed) redemption-at-risk is closest to:
- USD 39.5 millionWhy not: Uses only z x sigma and leaves out the 2% mean redemption.
- USD 63.0 millionWhy not: Uses the two-tailed 1.96 instead of the one-tailed 1.645 for 95%.
- USD 71.8 millionWhy not: Uses the 99% quantile (2.326) instead of the 95% quantile.
- USD 55.5 million - correct
RaR = mean + z x sigma = 2% + 1.645 x 3% = 6.93% of NAV. On USD 800 million that is 0.0693 x 800 = USD 55.5 million.
The hardest tier
A fund with NAV of USD 1,000 million estimates a one-week 99% redemption-at-risk of 8.5% of NAV. It holds USD 20 million in cash and wants cash plus a liquid bond bucket to cover RaR in full. In stress the bond bucket would sell for 90% of its carrying value. The minimum carrying value of the bond bucket is closest to:
- USD 65.0 millionWhy not: Ignores the stress haircut and treats the bucket as realising its full carrying value.
- USD 94.4 millionWhy not: Ignores the USD 20 million of cash and requires the bonds alone to cover the full RaR of 85 million.
- USD 72.2 million - correct
- USD 58.5 millionWhy not: Applies the haircut in the wrong direction, multiplying the 65 million need by 0.90.
RaR = 8.5% x 1,000 = 85 million. After cash of 20, 65 million must come from bonds that realise 90%. Carrying value = 65 / 0.90 = USD 72.2 million.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Liquidity Risk Management
- Explain the recommended ways for an investment fund to control its exposure to liquidity risk.
- Account for the potential difficulties fund managers meet in managing liquidity risk in fixed-income portfolios, data modeling included.
- Characterise and use the different approaches for modeling asset liquidity, among them one for bonds that trade rarely and the t-cost model for working out transaction costs on corporate bonds.
- Name emergency tools that regulators can let funds use when redemption demands are unforeseen, and explain the circumstances in which each is permitted.