Liquidity Valuation Adjustment for Standby Swaps

Abstract

This paper outlines an approach to calculating a liquidity valuation adjustment (LVA) for standby swaps, which are credit instruments used in securitisation markets to transfer rating agency obligations between swap providers. We define the LVA of a standby swap in the presence of correlation between interest rates and default, as the expected cost associated with an idealised hedging strategy that replicates a default-contingent fixed rate swap exposure. In this sense the LVA can be interpreted as articulating a market price of liquidity under the threat of a future financial crisis scenario. We present valuation formulae that allow for the formalisation of market makers' liquidity risk preferences in terms of a correlation spread.