Landmarks in XVA
First published:
ISBN: 9781782722939
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Risky Funding: A Unified Framework for Counterparty and Liquidity Charges
Massimo Morini and Andrea Prampolini
Introduction
Preface to Chapter 1
Being Two-Faced over Counterparty Credit Risk
Risky Funding: A Unified Framework for Counterparty and Liquidity Charges
DVA for Assets
Pricing CDSs’ Capital Relief
The FVA Debate
The FVA Debate: Reloaded
Regulatory Costs Break Risk Neutrality
Risk Neutrality Stays
Regulatory Costs Remain
Funding beyond Discounting: Collateral Agreements and Derivatives Pricing
Cooking with Collateral
Options for Collateral Options
Partial Differential Equation Representations of Derivatives with Bilateral Counterparty Risk and Funding Costs
In the Balance
Funding Strategies, Funding Costs
The Funding Invariance Principle
Regulatory-Optimal Funding
Close-Out Convention Tensions
Funding, Collateral and Hedging: Arbitrage-Free Pricing with Credit, Collateral and Funding Costs
Bilateral Counterparty Risk with Application to Credit Default Swaps
KVA: Capital Valuation Adjustment by Replication
From FVA to KVA: Including Cost of Capital in Derivatives Pricing
Warehousing Credit Risk: Pricing, Capital and Tax
MVA by Replication and Regression
Smoking Adjoints: Fast Evaluation of Monte Carlo Greeks
Adjoint Greeks Made Easy
Bounding Wrong-Way Risk in Measuring Counterparty Risk
Wrong-Way Risk the Right Way: Accounting for Joint Defaults in CVA
Backward Induction for Future Values
A Non-Linear PDE for XVA by Forward Monte Carlo
Efficient XVA Management: Pricing, Hedging and Allocation
Accounting for KVA under IFRS 13
FVA Accounting, Risk Management and Collateral Trading
Derivatives Funding, Netting and Accounting
Managing XVA in the Ring-Fenced Bank
XVA: A Banking Supervisory Perspective
An Annotated Bibliography of XVA
The pricing of funding liquidity and the pricing of counterparty credit risk are closely related. Companies usually compute a spread for funding costs that includes a 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 chapter we try to provide the cornerstones of a unified consistent framework for liquidity and credit risk adjustments that can help banks in this process.
We first argue that a naive application of the standard approach to including funding costs by modifying the discounting rate, when it is put in place together with the standard approach for the computation of credit value adjustment (CVA) and debt value adjustment (DVA) leads to double-counting of assets that can be realised only once. Here we show how this issue can be avoided. We devise a practical and general approach to the problem by taking explicitly into account, in the valuation of a derivative, the funding strategy that needs to be put in place to manage the liquidity absorbed or generated by the derivative, and we study
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