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CCP Cleared or Bilateral CSA Trades with Initial/Variation Margins under credit, funding and wrong-way risks: A Unified Valuation Approach

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  • Damiano Brigo
  • Andrea Pallavicini

Abstract

The introduction of CCPs in most derivative transactions will dramatically change the landscape of derivatives pricing, hedging and risk management, and, according to the TABB group, will lead to an overall liquidity impact about 2 USD trillions. In this article we develop for the first time a comprehensive approach for pricing under CCP clearing, including variation and initial margins, gap credit risk and collateralization, showing concrete examples for interest rate swaps. Mathematically, the inclusion of asymmetric borrowing and lending rates in the hedge of a claim lead to nonlinearities showing up in claim dependent pricing measures, aggregation dependent prices, nonlinear PDEs and BSDEs. This still holds in presence of CCPs and CSA. We introduce a modeling approach that allows us to enforce rigorous separation of the interconnected nonlinear risks into different valuation adjustments where the key pricing nonlinearities are confined to a funding costs component that is analyzed through numerical schemes for BSDEs. We present a numerical case study for Interest Rate Swaps that highlights the relative size of the different valuation adjustments and the quantitative role of initial and variation margins, of liquidity bases, of credit risk, of the margin period of risk and of wrong way risk correlations.

Suggested Citation

  • Damiano Brigo & Andrea Pallavicini, 2014. "CCP Cleared or Bilateral CSA Trades with Initial/Variation Margins under credit, funding and wrong-way risks: A Unified Valuation Approach," Papers 1401.3994, arXiv.org.
  • Handle: RePEc:arx:papers:1401.3994
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    References listed on IDEAS

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    9. Andrea Pallavicini & Marco Tarenghi, 2010. "Interest-Rate Modeling with Multiple Yield Curves," Papers 1006.4767, arXiv.org.
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    11. Andrea Pallavicini & Damiano Brigo, 2013. "Interest-Rate Modelling in Collateralized Markets: Multiple curves, credit-liquidity effects, CCPs," Papers 1304.1397, arXiv.org.
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    14. Damiano Brigo & Andrea Pallavicini, 2013. "CCPs, Central Clearing, CSA, Credit Collateral and Funding Costs Valuation FAQ: Re-hypothecation, CVA, Closeout, Netting, WWR, Gap-Risk, Initial and Variation Margins, Multiple Discount Curves, FVA?," Papers 1312.0128, arXiv.org, revised Dec 2013.
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    Cited by:

    1. Stéphane Crépey & Shiqi Song, 2014. "BSDEs of Counterparty Risk," Working Papers hal-01088941, HAL.
    2. Meng Han & Yeqi He & Hu Zhang, 2014. "A note on discounting and funding value adjustments for derivatives," Journal of Financial Engineering (JFE), World Scientific Publishing Co. Pte. Ltd., vol. 1(01), pages 1-34.
    3. Wujiang Lou, 2015. "MVA Transfer Pricing," Papers 1512.07337, arXiv.org, revised Jul 2016.

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