An Average-Strike Put Option Model of the Marketability Discount

Abstract

Liquidity is the ability to buy or sell a security quickly with relatively little impact on the price. The most extreme example of an illiquid asset is one that cannot be traded at all, such as restricted stock under SEC Rule 144. The ability to sell a stock is a valuable option, the loss of which should produce a “marketability discount” relative to the same stock without the restriction. Previous work on Rule 144 stock derived an upper bound on the value of the marketability option by modeling it as a put on the maximum stock price over the restriction period. But an investor would require perfect foresight to actually attain that upper bound. Finnerty argues that a better assumption is that the investor has no special timing ability, so the option to sell should be closer to a put on the average price. Using this model, he finds that it tends to understate the observed marketability discount, but the theoretical option value is highly significant in regressions on the discount in over 200 private placements.