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1 – 1 of 1Lixin Wu and Chonhong Li
The purpose of this paper is to provide a framework of replication pricing of derivatives and identify funding valuation adjustment (FVA) and credit valuation adjustments (CVA) as…
Abstract
Purpose
The purpose of this paper is to provide a framework of replication pricing of derivatives and identify funding valuation adjustment (FVA) and credit valuation adjustments (CVA) as price components.
Design/methodology/approach
The authors propose the notion of bilateral replication pricing. In the absence of funding cost, it reduces to unilateral replication pricing. The absence of funding costs, it introduces bid–ask spreads.
Findings
The valuation of CVA can be separated from that of FVA, so-called split up. There may be interdependence between FVA and the derivatives value, which then requires a recursive procedure for their numerical solution.
Research limitations/implications
The authors have assume deterministic interest rates, constant CDS rates and loss rates for the CDS. The authors have also not dealt with re-hypothecation risks.
Practical implications
The results of this paper allow user to identify CVA and FVA, and mark to market their derivatives trades according to the recent market standards.
Originality/value
For the first time, a line between the risk-neutral pricing measure and the funding risk premiums is drawn. Also, the notion of bilateral replication pricing extends the unilateral replication pricing.
Details