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The price of liquidity in the reinsurance of fund returns

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Listed:
  • David Saunders
  • Luis Seco
  • Markus Senn

Abstract

We consider a new type of contract for insuring the returns of hedge funds and aim to extend downside protection to an investment portfolio beyond the first tranche of losses insured by first-loss fee structures, which have become increasingly popular in the market. By considering a second tranche, we suggest an up-front premium to a reinsurance party, in exchange for which the investor gains full protection against all losses, not just those occurring in the first tranche. We identify a fund’s underlying liquidity as a key parameter in deriving the price for the additional reinsurance and provide a method for computing the premium using two approaches: an analytic closed-form solution based on the Black–Scholes framework, and a numerical simulation using a Markov-switching model. In addition, a simplified backtesting method is implemented to evaluate the practical application and performance of the concept for both mathematical models.

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Handle: RePEc:rsk:journ6:7820081
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File URL: https://www.risk.net/system/files/digital_asset/2021-04/The_price_of_liquidity_in_the_reinsurance_of_fund_returns_final.pdf
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