In the Balance

Christoph Burgard and Mats Kjaer

Funding costs and the bilateral counterparty credit risk of derivatives positions have become increasingly hot topics since the beginning of the credit crisis in 2008. It has become standard practice to adjust derivatives prices for the counterparty risk. Similarly, funding costs are increasingly incorporated into derivatives prices one way or another, but the conceptual foundations for such funding adjustments are much less well understood.

Piterbarg (2010) showed how the funding costs of delta hedging affect derivatives pricing. Subsequently, Burgard and Kjaer (2011) developed a unified framework that combines funding costs and bilateral counterparty credit risk. This framework specifies how a positive cash account related to the hedging strategy of an uncollateralised derivative can be used to fund the repurchase of the issuer’s own bonds in order to hedge its own credit risk. This demonstrates that the debit value adjustment (DVA) is equivalent to a funding benefit adjustment and justifies its inclusion in a bilateral counterparty value adjustment. The framework also includes the funding costs associated with a negative cash account, and yields a corresponding additional