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Valuation of Illiquid Assets on Bank Balance Sheets

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

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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.

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