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A note on discounting and funding value adjustments for derivatives

Author

Listed:
  • Meng Han

    (RBC Financial Group, 200 Bay Street, 11th Floor, South Tower, Toronto, ON M5J 2J5, Canada)

  • Yeqi He

    (RBC Financial Group, 200 Bay Street, 11th Floor, South Tower, Toronto, ON M5J 2J5, Canada)

  • Hu Zhang

    (Morgan Stanley, 750 Seventh Avenue, New York, NY 10019, USA)

Abstract

In this paper, valuation of a derivative partially collateralized in a specific foreign currency defined in its credit support annex traded between default-free counterparties is studied. Two pricing approaches — by hedging and by expectation — are presented to obtain similar valuation formulae which are equivalent under certain conditions. Our findings show that the current marking-to-market value of such a derivative consists of three components: the price of the perfectly collateralized derivative (a.k.a. the price by collateral rate discounting), the value adjustment due to different funding spreads between the payoff currency and the collateral currency, and the value adjustment due to funding requirements of the uncollateralized exposure. These results generalize previous works on discounting for fully collateralized derivatives and on funding value adjustments for partially collateralized or uncollateralized derivatives.

Suggested Citation

  • Meng Han & Yeqi He & Hu Zhang, 2014. "A note on discounting and funding value adjustments for derivatives," Journal of Financial Engineering (JFE), World Scientific Publishing Co. Pte. Ltd., vol. 1(01), pages 1-34.
    • Handle: RePEc:wsi:jfexxx:v:01:y:2014:i:01:n:s2345768614500081
    DOI: 10.1142/S2345768614500081
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    References listed on IDEAS

    as
    1. Andrea Pallavicini & Daniele Perini & Damiano Brigo, 2011. "Funding Valuation Adjustment: a consistent framework including CVA, DVA, collateral,netting rules and re-hypothecation," Papers 1112.1521, arXiv.org, revised Dec 2011.
    2. Damiano Brigo & Andrea Pallavicini, 2014. "CCP Cleared or Bilateral CSA Trades with Initial/Variation Margins under credit, funding and wrong-way risks: A Unified Valuation Approach," Papers 1401.3994, arXiv.org.
    3. Andrea Pallavicini & Daniele Perini & Damiano Brigo, 2012. "Funding, Collateral and Hedging: uncovering the mechanics and the subtleties of funding valuation adjustments," Papers 1210.3811, arXiv.org, revised Dec 2012.
    4. Tomasz R. Bielecki & Marek Rutkowski, 2013. "Valuation and hedging of OTC contracts with funding costs, collateralization and counterparty credit risk: Part 1," Papers 1306.4733, arXiv.org, revised Jun 2013.
    5. Damiano Brigo & Andrea Pallavicini, 2014. "Nonlinear consistent valuation of CCP cleared or CSA bilateral trades with initial margins under credit, funding and wrong-way risks," Journal of Financial Engineering (JFE), World Scientific Publishing Co. Pte. Ltd., vol. 1(01), pages 1-60.
    Full references (including those not matched with items on IDEAS)

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