A Model for the Valuation of Assets with Liquidity Risk

Nauta, Bert-Jan (2016): A Model for the Valuation of Assets with Liquidity Risk. Published in: Journal of Risk (5 December 2017)

Abstract

This paper describes a model for the valuation of assets on a bank balance sheet with liquidity risk. The new feature of this model is that it explicitly incorporates the funding term of an asset. The inclusion of the funding term is important since it determines the expected liquidation loss. By minimizing the sum of the expected liquidation loss and funding costs the optimal funding term and value of the asset can be determined. This paper applies the model to single cash flows, loans, bonds, and derivatives. Also, the calibration to LIBOR basis spreads is discussed.

• Item Type: MPRA Paper
• Language: English
• Keywords: Valuation, Liquidity Risk, funding costs, discounting, FVA, XVA
• 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 > G20 - General

References

C. Albanese and L. Andersen. Accounting for otc derivatives: Funding adjustments and the re-hypothecation opion. Available at SSRN: http://dx.doi.org/10.2139/ssrn.2482955, 2014.

F. M. Ametrano and M. Bianchett. Curves and term structure models: Definition, calibration and application of rate curves and term structure models. Available at SSRN: http://dx.doi.org/10.2139/ssrn.2194907, 2013.

L. Becker and N. Sherif. The black art of fva, part iii: a $4 billion mistake? Risk magazine, 2015.

C. Burgard and M. Kjaer. Partial differential equation representations of derivatives with bilateral counterparty risk and funding costs. The Journal of Credit Risk, 2010.

C. Burgard and M. Kjaer. In the balance. Risk Magazine, 2011.

Y. Chang and E. Schlogl. A consistent framework for modelling basis spreads in tenor swaps. Available at SSRN: http://dx.doi.org/10.2139/ssrn.2433829, 2014.

A. Damodaran. Investment Valuation: Tools and Techniques for Determining the Value of any Asset. John Wiley and Sons, second edition edition, 2002.

C. Fries. Everything you always wanted to know about multiple interest rate curve bootstrapping but were afraid to ask. Available at SSRN: http://dx.doi.org/10.2139/ssrn.2219548, 2013.

A. Green and C. Kenyon. Mva: Initial margin valuation adjustment by replication and regression. Available at SSRN: http://dx.doi.org/10.2139/ssrn.2432281, 2014.

J. Hull. Options, Futures and Other Derivatives. Prentice Hall, 7th edition, 2008.

J. Hull and A. White. Valuing derivatives: Funding value adjustments and fair value. Financial Analysts Journal, 2014.

B. J. Nauta. Liquidity risk, instead of funding costs, leads to valuation adjustments for derivatives and other assets. International Journal of Theoretical and Applied Finance, 2015a.

B. J. Nauta. Fva and liquidity risk. Available at SSRN: http://dx.doi.org/10.2139/ssrn.2373147, 2015b.

B. J. Nauta. Optimal funding term of posted collateral. Review of Financial Markets, 2015c.

V. Piterbarg. Funding beyond discounting: collateral agreements and derivatives pricing. Risk magazine, 2010.