Regulatory costs break risk neutrality

Regulations impose idiosyncratic capital and funding costs for holding derivatives. Idiosyncratic costs mean that no single measure makes derivatives martingales for all market participants. Chris Kenyon and Andrew Green demonstrate that regulatory-compliant pricing cannot be risk neutral, which in turn has implications for exit prices and mark-to-market

bank-cracking

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Increased regulation and market changes since 2007 have altered the perceived costs of many financial products. Here we prove that these changes are not just perception: they have had a fundamental effect on pricing theory. That is, we prove a market-wide risk-neutral measure that is common to all participants does not exist. This proof is based on our theorem 2, which states that if different market participants receive different dividends for holding the same stock

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