A Model for Estimating the Liquidity Valuation Adjustment on OTC Derivatives

Umberto Cherubini and Sabrina Mulinacci

This article was first published as a chapter in Managing Illiquid Assets: Perspectives and Challenges, by Risk Books.

Consider a wealthy individual willing to buy a derivative contract, say a call option, on a large amount of the underlying asset, a “block”, as it is called in the market microstructure literature. They have to choose between two main alternatives. The first is to design a replication strategy equivalent to the derivative contract and to implement it on his own. The other is to look for a specialised intermediary, in some financial marketplace, such as the City of London or Wall Street, which would be willing to write the contract for them. In the latter case, the intermediary would implement the replication strategy on the buyer’s behalf, and would charge them the replicating cost plus a fee. Since the underlying is a large amount, implementing the dynamic hedging strategy would imply price impacts on the market that represent the liquidity cost of the replicating strategy. The intermediary would then add this cost to the fair value of the derivative contract: we call this addon the liquidity valuation adjustment (LVA) of the contract. Then the intermediary

Want to know what’s included in our free membership? Click here

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here