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Discounting Cashflows from Illiquid Assets on Bank Balance Sheets

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  • Nauta, Bert-Jan

Abstract

Most of the assets on the balance sheet of typical banks are illiquid. This exposes banks to liquidity risk, which is one of the key risks for banks. Since the value of assets is determined by their risks, liquidity risk should be included in valuation. This paper develops a valuation framework for liquidity risk. An important element of the framework is the definition and derivation of an optimal admissible liquidation strategy that describes the assets a bank will liquidate in case of a liquidity stress event (LSE). The main result is that the discount rate includes a liquidity spread that is composed of three elements: 1. the probability of an LSE, 2. the severity of an LSE, and 3. the liquidation value of the asset. The framework is illustrated by application to a stylized bank balance sheet.

Suggested Citation

  • Nauta, Bert-Jan, 2013. "Discounting Cashflows from Illiquid Assets on Bank Balance Sheets," MPRA Paper 54781, University Library of Munich, Germany, revised 22 Oct 2013.
    • Handle: RePEc:pra:mprapa:54781
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    References listed on IDEAS

    as
    1. Acharya, Viral V. & Pedersen, Lasse Heje, 2005. "Asset pricing with liquidity risk," Journal of Financial Economics, Elsevier, vol. 77(2), pages 375-410, August.
    2. Dion Bongaerts & Frank De Jong & Joost Driessen, 2011. "Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 66(1), pages 203-240, February.
    3. Rama Cont & Arseniy Kukanov & Sasha Stoikov, 2013. "The Price Impact of Order Book Events," Journal of Financial Econometrics, Oxford University Press, vol. 12(1), pages 47-88, December.
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    More about this item

    Keywords

    valuation; liquidity spread; discounting; liquidity risk;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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