Hedging and the Estimation of Marketability Discounts

15 August 2003
By Dr. David Tabak

This article examines the link between security price hedging and discounts for lack of marketability. Dr. Tabak notes that when estimating discounts for lack of marketability, many analysts do not consider the differences between different types of restrictions on marketability. Some of these restrictions may be avoided by hedging, thereby allowing the owner of the illiquid asset to bear less than the full cost of illiquidity. Dr. Tabak suggests that both short selling and the zero-cost, or cashless, collar can sometimes be simple, effective methods for hedging price risk. In addition, owners of illiquid assets may be able to partially hedge their positions through transactions such as equity swaps and shorting an appropriate index or buying a put on that index. Because not all marketability restrictions therefore impose the full costs of nonmarketability on the owner, these hedging transactions affect the commonly-used data on the size of average marketability discounts.

Dr. Tabak concludes that when calculating a discount for lack of marketability, a valuation analyst needs to gather certain data. Some data, such as the nature of the illiquid asset and the likely period of illiquidity, relate to the costs of bearing the risk of holding the illiquid asset. Other data, however, are needed to know whether that cost must be borne or can be reduced or eliminated through some financial transaction. Analysts therefore must exercise caution when measuring the holding risk of nonmarketable assets, with an awareness that the data on the size of reported discounts for certain transactions may contain biases that push measured values to both underestimate and overestimate that cost.

This article was published in Shannon Pratt's Business Valuation Update, Volume 9, Number 8, August 2003.