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Internal Valuation of Assets with Liquidity Risk

Bert-Jan Nauta
The Journal of Derivatives Spring 2017, 24 (3) 70-83; DOI: https://doi.org/10.3905/jod.2017.24.3.070
Bert-Jan Nauta
is the head of the expert centre financial risks of insurers at the Dutch Central Bank in Amsterdam, the Netherlands.
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  • For correspondence: b.j.nauta@dnb.nl
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Abstract

FVA, funding valuation adjustment, is a new and controversial adjustment to the value of a firm’s derivatives position, joining CVA (credit valuation adjustment) and DVA (debt valuation adjustment), both of which attempt to account for the effects of counterparty credit risk on the value of a contract on a firm’s books. FVA adjusts for the fact that an investor who holds a security but finances it in the money market will have to pay a premium over the riskless rate in order to do so. This premium reduces the investment value of the position by an amount that is supposed to be captured by the FVA. The problem that Nauta raises is that this treatment does not distinguish between a security that is traded in a liquid market and can be sold for its fair value at any time, meaning overnight funding is OK, versus an illiquid security that must be financed through maturity. The article shows how this key difference translates into a liquidity-based FVA and an optimal funding horizon for less than perfectly liquid assets.

TOPICS: Counterparty risk, quantitative methods, credit risk management

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The Journal of Derivatives: 24 (3)
The Journal of Derivatives
Vol. 24, Issue 3
Spring 2017
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Internal Valuation of Assets with Liquidity Risk
Bert-Jan Nauta
The Journal of Derivatives Feb 2017, 24 (3) 70-83; DOI: 10.3905/jod.2017.24.3.070

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Internal Valuation of Assets with Liquidity Risk
Bert-Jan Nauta
The Journal of Derivatives Feb 2017, 24 (3) 70-83; DOI: 10.3905/jod.2017.24.3.070
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  • Article
    • Abstract
    • DEFINITION OF INTERNAL VALUE
    • VALUATION WITH LIQUIDITY RISK
    • COMBINING MODELS BASED ON LIQUIDITY HORIZON FUNDING AND LIQUIDATION LOSSES
    • EMPIRICAL TEST
    • SUMMARY
    • ENDNOTES
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