CONIC CVA AND DVA FOR OPTION PORTFOLIOS

Sjoerd van Bakel (), Svetlana Borovkova and Matteo Michielon ()
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Sjoerd van Bakel: ABN AMRO Bank N.V., Gustav Mahlerlaan 10, 1082 PP Amsterdam, The Netherlands
Svetlana Borovkova: #x2020;Vrije Universiteit, School of Business and Economics, Finance, De Boelelaan 1105, 1081 HV Amsterdam, The Netherlands
Matteo Michielon: ABN AMRO Bank N.V., Gustav Mahlerlaan 10, 1082 PP Amsterdam, The Netherlands

International Journal of Theoretical and Applied Finance (IJTAF), 2020, vol. 23, issue 05, 1-30

Abstract: In this paper, we propose a framework for credit and debit valuation adjustments (CVA and DVA, respectively) for options and option portfolios which is based on conic finance, that is, where the positions are valued at their bid or ask prices depending on whether they are assets or liabilities. This can be achieved by transforming the pricing measure via appropriate distortion functions, depending on (at least) one parameter. We apply our methodology, which is based on the Wang transform, to portfolios of European commodity futures options, and we show that both CVA and DVA are significantly impacted by bid-ask spreads, when compared to their traditional risk-neutral counterparts. In particular, we show that DVA decreases when computed under conic finance settings, which is in line with the regulatory efforts to rein in DVA gains for financial institutions resulting from their own credit quality deterioration. Finally, we investigate the robustness of our approach with respect to the calibrated parameters, and we show that the calibrated distortion parameter is an excellent explanatory variable for the observed bid-ask spreads.

Keywords: Conic finance; CVA; DVA; bid-ask spread; liquidity; commodity option; futures option; distortion function; Wang transform; Black model (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1142/S0219024920500326

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