Price of liquidity in the reinsurance of fund returns

TL;DR

This paper investigates the pricing of liquidity-related reinsurance in hedge fund portfolios, proposing models to evaluate the cost of downside protection through shared loss fee structures.

Contribution

It introduces a novel approach to price liquidity risk in hedge fund reinsurance using both analytical and numerical methods, including a practical backtesting framework.

Findings

Analytic solution based on Black-Scholes for reinsurance pricing

Numerical simulation with Markov-switching model

Backtesting method for practical evaluation

Abstract

This paper aims to extend downside protection to a hedge fund investment portfolio based on shared loss fee structures that have become increasing popular in the market. In particular, we consider a second tranche and suggest the purchase of an upfront reinsurance contract for any losses on the fund beyond the threshold covered by the first tranche, i.e. gaining full portfolio protection. We identify a fund's underlying liquidity as a key parameter and study the pricing of this additional reinsurance using two approaches: First, an analytic closed-form solution based on the Black-Scholes framework and second, a numerical simulation using a Markov-switching model. In addition, a simplified backtesting method is implemented to evaluate the practical application of the concept.