Funding, repo and credit inclusive valuation as modified option pricing

We take the holistic approach of computing an OTC claim value that incorporates credit and funding liquidity risks and their interplays, instead of forcing individual price adjustments: CVA, DVA, FVA, KVA. The resulting nonlinear mathematical problem features semilinear PDEs and FBSDEs. We show that for the benchmark vulnerable claim there is an analytical solution, and we express it in terms of the Black-Scholes formula with dividends. This allows for a detailed valuation analysis, stress testing and risk analysis via sensitivities.Comment: 1 figur

Illustrating a problem in the self-financing condition in two 2010-2011 papers on funding, collateral and discounting

We illustrate a problem in the self-financing condition used in the papers "Funding beyond discounting: collateral agreements and derivatives pricing" (Risk Magazine, February 2010) and "Partial Differential Equation Representations of Derivatives with Counterparty Risk and Funding Costs" (The Journal of Credit Risk, 2011). These papers state an erroneous self-financing condition. In the first paper, this is equivalent to assuming that the equity position is self-financing on its own and without including the cash position. In the second paper, this is equivalent to assuming that a subportfolio is self-financing on its own, rather than the whole portfolio. The error in the first paper is avoided when clearly distinguishing between price processes, dividend processes and gain processes. We present an outline of the derivation that yields the correct statement of the self-financing condition, clarifying the structure of the relevant funding accounts, and show that the final result in "Funding beyond discounting" is correct, even if the self-financing condition stated is not.Comment: added references, a footnote and updated abstrac

Impact of the first to default time on Bilateral CVA

We compare two different bilateral counterparty valuation adjustment (BVA) formulas. The first formula is an approximation and is based on subtracting the two unilateral Credit Valuation Adjustment (CVA)'s formulas as seen from the two different parties in the transaction. This formula is only a simplified representation of bilateral risk and ignores that upon the first default closeout proceedings are ignited. As such, it involves double counting. We compare this formula with the fully specified bilateral risk formula, where the first to default time is taken into account. The latter correct formula depends on default dependence between the two parties, whereas the simplified one does not. We also analyze a candidate simplified formula in case the replacement closeout is used upon default, following ISDA's recommendations, and we find the simplified formula to be the same as in the risk free closeout case. We analyze the error that is encountered when using the simplified formula in a couple of simple products: a zero coupon bond, where the exposure is unidirectional, and an equity forward contract where exposure can go both ways. For the latter case we adopt a bivariate exponential distribution due to Gumbel to model the joint default risk of the two parties in the deal. We present a number of realistic cases where the simplified formula differs considerably from the correct one

Analytical valuation of vulnerable derivative contracts with bilateral cash flows under credit, funding and wrong-way risks

We study the problem of valuing a vulnerable derivative with bilateral cash flows between two counterparties in the presence of funding, credit and wrong-way risks, and derive a closed-form valuation formula for an at-the-money (ATM) forward contract as well as a second order approximation for the general case. We posit a model with heterogeneous interest rates and default occurrence and infer a Cauchy problem for the pre-default valuation function of the contract, which includes ab initio any counterparty risk - as opposed to calculating valuation adjustments collectively known as XVA. Under a specific funding policy which linearises the Cauchy problem, we obtain a generic probabilistic representation for the pre-default valuation (Theorem 1). We apply this general framework to the valuation of an equity forward and establish the contract can be expressed as a continuous portfolio of European options with suitably chosen strikes and expiries under a particular probability measure (Theorem 2). Our valuation formula admits a closed-form expression when the forward contract is ATM (Corollary 2) and we derive a second order approximation in moneyness when the contract is close to ATM (Theorem 3). Numerical results of our model show that the forward is more sensitive to funding factors than credit ones, while higher stock funding costs increase sensitivity to credit spreads and wrong-way risk.Comment: 43 pages, 4 figure