The CAIA Association posted a paper by Ranjan Bhaduri, Gunter Meissner, and James Youn that introduces five new derivatives designed specifically for liquidity risk: Hedging Liquidity Risk: Potential Solutions for Hedge Funds (visit CAIA site for the PDF). They are illustrated in the context of a hedge fund investment that is typically illiquid due to a lock-up period (e.g., investor cannot withdraw for two years)

• Withdrawal option: right to transfer illiquid investment to the option seller at the market price (sort of like a put, but without a fixed strike price. As such, it is not protecting against a value decline, only against illiquidity)
• Bermuda-style return put option: right to put (swap) the investment (like a typical put) in exchange for predetermined strike; so this is like a regular put
• Return swap: swap fund return for LIBOR (I'm not sure about this one. The liquidity feature is the ability to swap into immediate fixed-rate cash flows. But the investor is swapping valuation changes, too.)
• Return swaption: an option to enter into the return swap above
• Liquidity option: They don't call it so, but this appears to be a "knock-in" barrier option, where the barrier is a liquidity metric (very interesting!). For example, investor holds bond and buys a liquidity option that is "knocked into" existence only if the bond's liquidity reaches some low barrier (e.g., trading volume falls below X for Y consecutive days). If barrier is reached (option knocks-in), investor has the right to sell the bond to the option seller at the market price.

Categories of liquidity risk

For FRM candidates (Meissner is an assigned author), I liked their categorization of liquidity risk. I redrew their relationships below. Note two things: one, liquidity risk is a type of market risk. Two, liquidity risk is of two sorts: asset (market liquidity; e.g., "we can't exit this position without discounting") and funding risk (e.g., "we can't raise funds to pursue opportunities or maintain operations").

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