Nonlinear Valuation Under Collateral, Credit Risk and Funding Costs: A Numerical Case Study Extending Black-Scholes

Veronesi, P. (Editor), Handbook in Fixed-Income Securities, Wiley, 2014

28 Pages Posted: 29 Apr 2014

See all articles by Damiano Brigo

Damiano Brigo

Imperial College London - Department of Mathematics

Qing Liu

Imperial College London-Department of Mathematics

Andrea Pallavicini

Banca IMI; Imperial College London - Department of Mathematics

David Sloth

Danske Bank - Danske Markets

Date Written: April 29, 2014

Abstract

We develop an arbitrage-free framework for consistent valuation of derivative trades with collateralization, counterparty credit gap risk, and funding costs, following the approach first proposed by Pallavicini and co-authors in 2011. Based on the risk-neutral pricing principle, we derive a general pricing equation where Credit, Debit, Liquidity and Funding Valuation Adjustments (CVA, DVA, LVA and FVA) are introduced by simply modifying the payout cash-flows of the deal. Funding costs and specific close-out procedures at default break the bilateral nature of the deal price and render the valuation problem a non-linear and recursive one. CVA and FVA are in general not really additive adjustments, and the risk for double counting is concrete. We introduce a new adjustment, called a Non-linearity Valuation Adjustment (NVA), to address double-counting. Our framework is based on real market rates, since the theoretical risk free rate disappears from our final equations. The framework addresses common market practices of ISDA governed deals without restrictive assumptions on collateral margin payments and close-out netting rules, and can be tailored also to CCP trading under initial and variation margins, as explained in detail in Brigo and Pallavicini (2014). In particular, we allow for asymmetric collateral and funding rates, replacement close-out and re-hypothecation. The valuation equation takes the form of a backward stochastic differential equation or semi-linear partial differential equation, and can be cast as a set of iterative equations that can be solved by least-squares Monte Carlo. We propose such a simulation algorithm in a case study involving a generalization of the benchmark model of Black and Scholes for option pricing. Our numerical results confirm that funding risk has a non-trivial impact on the deal price, and that double counting matters too. We conclude the article with an analysis of large scale implications of non-linearity of the pricing equations: non-separability of risks, aggregation dependence in valuation, and local pricing measures as opposed to universal ones. This prompts a debate and a comparison between the notions of price and value, and will impact the operational structure of banks. This paper is an evolution, in particular, of the work by allavicini et al. (2011, 2012), Pallavicini and Brigo (2013), and Sloth (2013).

Keywords: Credit Valuation Adjustment, Counterparty Credit Risk, Funding Valuation Adjustment, Funding Costs, Collateralization, Non-linearity Valuation Adjustment, Derivatives Pricing, CVA, DVA, LVA, FVA, NVA, Funding-DVA, semi-linear PDE, BSDE, Nonlinear Valuation, Nonlinear Feynman-Kac, Least-squares Monte

JEL Classification: G12, G13

Suggested Citation

Brigo, Damiano and Liu, Qing and Pallavicini, Andrea and Sloth, David, Nonlinear Valuation Under Collateral, Credit Risk and Funding Costs: A Numerical Case Study Extending Black-Scholes (April 29, 2014). Veronesi, P. (Editor), Handbook in Fixed-Income Securities, Wiley, 2014. Available at SSRN: https://ssrn.com/abstract=2430696

Damiano Brigo

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.imperial.ac.uk/people/damiano.brigo

Qing Liu (Contact Author)

Imperial College London-Department of Mathematics ( email )

South Kensington Campus,Imperial College
LONDON, SW7 2AZ
United Kingdom

Andrea Pallavicini

Banca IMI ( email )

Largo Mattioli 3
Milan, MI 20121
Italy
+39 02 7261 (Phone)

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

David Sloth

Danske Bank - Danske Markets ( email )

Holmens Kanal 2-12
DK-1092 Copenhagen K
Denmark

Register to save articles to
your library

Register

Paper statistics

Downloads
455
Abstract Views
2,178
rank
62,299
PlumX Metrics