A Bond Consistent Derivative Fair Value
38 Pages Posted: 24 Jun 2014 Last revised: 19 Sep 2014
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A Bond Consistent Derivative Fair Value
A Bond Consistent Derivative Fair Value
Date Written: June 22, 2014
Abstract
In this paper we present a rigorously motivated pricing equation for derivatives, including general collateralization schemes, which is consistent with quoted market bond prices. Traditionally, there have been differences in how instruments with similar cash flow structures have been priced if their definition falls under that of a financial derivative versus if they correspond to bonds, leading to possibilities such as funding through derivatives transactions. Furthermore, the problem has not been solved with the recent introduction of Funding Valuation Adjustments in derivatives pricing, and in some cases has even been made worse.
In contrast, our proposed equation is not only consistent with fixed income assets and liabilities, but is also symmetric, implying a well-defined exit price, independent of the entity performing the valuation. Also, we provide some practical proxies, such as first-order approximations or basing calculations of CVA and DVA on bond curves, rather than Credit Default Swaps.
Keywords: CVA, DVA, FVA, Fair Value, IFRS 13, Funding, Derivatives, Securities Pricing, Replication, Credit
JEL Classification: G13, G32, H63, M41
Suggested Citation: Suggested Citation