A note on discounting and funding value adjustments for derivatives

Meng Han (), Yeqi He () and Hu Zhang ()
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Meng Han: RBC Financial Group, 200 Bay Street, 11th Floor, South Tower, Toronto, ON M5J 2J5, Canada
Yeqi He: RBC Financial Group, 200 Bay Street, 11th Floor, South Tower, Toronto, ON M5J 2J5, Canada
Hu Zhang: Morgan Stanley, 750 Seventh Avenue, New York, NY 10019, USA

Journal of Financial Engineering (JFE), 2014, vol. 01, issue 01, 1-34

Abstract: In this paper, valuation of a derivative partially collateralized in a specific foreign currency defined in its credit support annex traded between default-free counterparties is studied. Two pricing approaches — by hedging and by expectation — are presented to obtain similar valuation formulae which are equivalent under certain conditions. Our findings show that the current marking-to-market value of such a derivative consists of three components: the price of the perfectly collateralized derivative (a.k.a. the price by collateral rate discounting), the value adjustment due to different funding spreads between the payoff currency and the collateral currency, and the value adjustment due to funding requirements of the uncollateralized exposure. These results generalize previous works on discounting for fully collateralized derivatives and on funding value adjustments for partially collateralized or uncollateralized derivatives.

Keywords: Derivative pricing; collateralization; funding and discounting; funding value adjustments; derivative hedging (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1142/S2345768614500081

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