Funding Value Adjustment and Incomplete Markets

Lorenzo Cornalba

Papers from arXiv.org

Abstract: Value adjustment of uncollateralized trades is determined within a risk-neutral pricing framework. When hedging such trades, investors cannot freely trade protection on their own name, thus facing an incomplete market. This fact is reflected in the non-uniqueness of the pricing measure, which is only constrained by the values of the hedging instruments tradable by the investor. Uncollateralized trades should then be considered not as derivatives but as new primary assets in the investor's economy. Different choices of the risk-neutral measure correspond to different completions of the market, based on the risk appetite of the investor, leading to different levels of value adjustments. We recover, in limiting cases, results well known in the literature.

Date: 2014-09
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