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Risky funding: a unified framework for counterparty and liquidity risk

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  • Morini, Massimo
  • Prampolini, Andrea

Abstract

We analyze the liquidity component in a derivative transaction where both counterparties can default, and the effect of a counterparty's default probability on his funding costs and benefits. The analysis shows that the value of a transaction is influenced not by the total cost of funding of a counterparty, but only by that component of the cost of funding corresponding to his bond-CDS basis spread, and this regulates which trades are possible in the market. Moreover, we find that the DVA can be represented as a funding benefit for the borrower, alternatively to the market standard that considers it a benefit coming from the borrower's own default risk.

Suggested Citation

  • Morini, Massimo & Prampolini, Andrea, 2010. "Risky funding: a unified framework for counterparty and liquidity risk," MPRA Paper 23555, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:23555
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    File URL: https://mpra.ub.uni-muenchen.de/24720/1/MPRA_paper_24720.pdf
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    References listed on IDEAS

    as
    1. Robert A. Jarrow & Stuart M. Turnbull, 2008. "Pricing Derivatives on Financial Securities Subject to Credit Risk," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 17, pages 377-409, World Scientific Publishing Co. Pte. Ltd..
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    Cited by:

    1. Jean-Paul Laurent & Philippe Amzelek & Joe Bonnaud, 2014. "An overview of the valuation of collateralized derivative contracts," Review of Derivatives Research, Springer, vol. 17(3), pages 261-286, October.
    2. Boukhobza, Ali & Maetz, Jerome, 2012. "CVA, Wrong Way Risk, Hedging and Bermudan Swaption," MPRA Paper 42144, University Library of Munich, Germany.

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    More about this item

    Keywords

    counterparty risk; CVA; DVA; funding; liquidity; bond-CDS basis;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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