Valuation of Illiquid Assets on Bank Balance Sheets

Nauta, Bert-Jan (2013): Valuation of Illiquid Assets on Bank Balance Sheets.

Abstract

Most of the assets on the balance sheet of a typical bank are illiquid. Therefore, liquidity risk is one of the key risks for banks. Since the risks of an asset affect its value, liquidity risk should be included in their valuation. Although models have been developed to include liquidity risk in the pricing of traded assets, these models do not easily extend to truly illiquid or non-traded assets. This paper develops a valuation framework for liquidity risk for these illiquid assets. Liquidity risk for illiquid assets is identified as the risk of assets being liquidated at a discount in a liquidity stress event (LSE). Whether or not a bank decides to liquidate an asset depends on its liquidation strategy. The appropriate strategy for valuation purposes is shown to be a pro rata liquidation. The main result is that the discount rate used for valuation includes a liquidity spread that is composed of three factors: 1. the probability of an LSE, 2. the severity of an LSE, and 3. the liquidation value of the asset.

• Item Type: MPRA Paper
• Language: English
• Keywords: valuation; liquidity spread; discounting; liquidity risk
• Subjects: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing ; Trading Volume ; Bond Interest Rates; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages

References

[1] V. Acharyay and L. Pedersen (2005) Asset Pricing with Liquidity Risk, Journal of Financial Economics 77, 375-410.

[2] Y. Amihud, H. Mendelson and L. Pedersen (2005) Liquidity and Asset Prices, Foundations and Trends in Finance 1, 269.

[3] Y. Amihud and H. Mendelson (1986) Asset pricing and the bid-ask spread, Journal of Financial Economics 17, 223-249.

[4] Barclays (2014), Barclays 2014 Results Tables FY, ”http://www.barclays.com/barclays-investor-relations/results-andreports/results.html”.

[5] Basel Committee on Banking Supervision (2010) Basel III: International framework for liquidity risk measurement, standards and monitoring.

[6] Bank for International Settlements (2008) Principles for sound liquidity risk management and supervision.

[7] C. Burgard and M. Kjaer (2011) Partial differential equation representations of derivatives with bilateral counterparty risk and funding costs, The Journal of Credit Risk 7, 75-93.

[8] C. Burgard and M. Kjaer (2013) Funding costs, funding strategies, Risk Dec 2013, 82-87.

[9] R. Cont, A. Kukanov, and S. Stoikov (2012) The price impact of order book events, Journal of Financial Econometrics 12 (1), 47-88.

[10] J. Grant (2011) Liquidity transfer pricing: a guide to better practice, BIS occasional paper No 10.

[11] B. J. Nauta (2015) Liquidity Risk, instead of Funding Costs, leads to a Valuation Adjustment for Derivatives and other Assets, International Journal of Applied and Theoretical Finance 18.

[12] B. J. Nauta (2013b) FVA and Liquidity Risk, Available at SSRN: http://ssrn.com/abstract=2373147.

[13] A. Obizhaeva (2008) The study of price impact and effective spread, Available at SSRN: http://ssrn.com/abstract=1178722.

[14] UBS (2014), UBS UBS group-timeseries-1q15, ”http://www.ubs.com/global/en/about ubs/investor relations”.