Risk Neutrality Stays
John C Hull and Alan D White
Risk Neutrality Stays
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 article written by Chris Kenyon and Andrew Green in the August 27, 2014, issue of Risk magazine, “Regulatory Costs Break Risk Neutrality”,11Kenyon and Green (2014); see Chapter 7 in this volume. is a refreshingly clearly written article, and we agree with much of it. There is certainly not a single risk-neutral measure for all market participants, and never has been. Pre-crisis, commercial and investment banks were regulated differently from each other. The attractiveness of a derivatives transaction to a market participant has always depended on how the participant is regulated, as well as other derivatives in its portfolio, liquidity considerations, and so on. If all market participants used the same risk-neutral measure, they would agree on the values for all derivatives and there would be no trading.
In our writings on funding valuation adjustments (FVAs) and related topics, we tried to emphasise the distinction between private values and fair-market values. Our arguments were concerned not with how much a dealer should charge for a product, but with how it should account for it. Similarly, although a single risk-neutral measure does not apply to the private values of all
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