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DERIVATIVE PRICING WITH COLLATERALIZATION AND FX MARKET DISLOCATIONS

Nicola Moreni () and Andrea Pallavicini ()
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Nicola Moreni: Quantitative Structuring, Banca IMI, Largo Mattioli, 3 Milan, 20121, Italy

International Journal of Theoretical and Applied Finance (IJTAF), 2017, vol. 20, issue 06, 1-27

Abstract: We present a general derivation of an arbitrage-free pricing framework for multiple-currency collateralized products. We include the impact on option pricing of the policy adopted to fund in foreign currency, so that we are able to price contracts with cash flows and/or collateral accounts expressed in foreign currencies inclusive of funding costs originating from dislocations in the foreign exchange market. Then, we apply these results to price cross-currency swaps under different market situations to understand how to implement a feasible curve bootstrap procedure. We present the main practical problems arising from the way the market is quoting liquid instruments: uncertainties about collateral currencies and renotioning features. We discuss the theoretical requirements to implement curve bootstrapping and the approximations usually taken to practically implement the procedure. We also provide numerical examples based on real market data.

Keywords: Arbitrage-free pricing; collateral; funding costs; foreign exchange market; curve bootstrapping; multiple currencies (search for similar items in EconPapers)
Date: 2017
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DOI: 10.1142/S0219024917500406

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