Risky funding with counterparty and liquidity charges

Standard techniques for incorporating liquidity costs into the fair value of derivatives produce counter-intuitive results when the credit risk of the counterparty and the investor are added to the picture. Here, Massimo Morini and Andrea Prampolini show that a consistent framework can only be achieved by giving an explicit representation of the funding strategy, including associated default risks

The pricing of funding liquidity and the pricing of counterparty credit risk are closely related. Companies usually calculate a spread for funding costs that includes compensation for their own risk of default. However, interactions between the two are still poorly understood, while banks are in need of a sound framework to underpin consistent policies for charging funding and credit costs. In this article, we try to provide the cornerstones of a unified consistent framework for liquidity and