26 Pages Posted: 6 Mar 2011 Last revised: 14 Apr 2011
Date Written: February 20, 2011
Funding costs are the costs to a (risky) institution of providing and managing its future cash flows in excess of, say, some risk free funding. For a single deterministic cash flow with maturity T these costs are essentially given by the ratio of the risky bond and the risk free bond. They can be expressed by a "funding spread", which represents an additional interest rate.
For stochastic cash flows funding can be interpreted as a dynamic hedging of future cash flows. The problem can also lead to a complex portfolio problem, see http://ssrn.com/abstract=1609587.
We will consider two possible valuations for a product consisting of future cash flows:
- The valuation which ignores any funding cost and calculates a liquidation value of the product. This valuation could be termed "mark-to-marked".
- The valuation including all funding costs from managing all future cash flows. This valuation could be termed "funded replication".
In this paper we will thoroughly introduce the valuation with funding, i.e. the "funded replication". We will also consider partial funding costs. For products with liquid market price we will derive a single consistent valuation: Having a liquid market price offers the option of canceling all future funding costs. This option can be valued.
The key points of this paper can be summarized as follows:
- The valuation of a derivative including funding corresponds to the valuation of a quanto product.
- Even a collateralized deal may bear some funding costs. These funding costs come from a correlation effect analog to the quanto adjustment.
- A liquid instrument having a market value represents the option to cancel all future funding. This option can be valued.
Keywords: Discounting, Valuation, Funding, Collateral, Mark to Market, Held to Maturity
JEL Classification: C15, G13
Suggested Citation: Suggested Citation