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Derivative Pricing With Collateralization And Fx Market Dislocations

Author

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  • NICOLA MORENI

    (Quantitative Structuring, Banca IMI, Largo Mattioli, 3 Milan, 20121, Italy)

  • ANDREA PALLAVICINI

    (Department of Mathematics, Imperial College London, London SW7 2AZ, UK)

Abstract

We present a general derivation of an arbitrage-free pricing framework for multiple-currency collateralized products. We include the impact on option pricing of the policy adopted to fund in foreign currency, so that we are able to price contracts with cash flows and/or collateral accounts expressed in foreign currencies inclusive of funding costs originating from dislocations in the foreign exchange market. Then, we apply these results to price cross-currency swaps under different market situations to understand how to implement a feasible curve bootstrap procedure. We present the main practical problems arising from the way the market is quoting liquid instruments: uncertainties about collateral currencies and renotioning features. We discuss the theoretical requirements to implement curve bootstrapping and the approximations usually taken to practically implement the procedure. We also provide numerical examples based on real market data.

Suggested Citation

  • Nicola Moreni & Andrea Pallavicini, 2017. "Derivative Pricing With Collateralization And Fx Market Dislocations," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(06), pages 1-27, September.
    • Handle: RePEc:wsi:ijtafx:v:20:y:2017:i:06:n:s0219024917500406
    DOI: 10.1142/S0219024917500406
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    References listed on IDEAS

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    1. Masaaki Fujii & Akihiko Takahashi, 2016. "A General Framework for the Benchmark pricing in a Fully Collateralized Market," CIRJE F-Series CIRJE-F-1000, CIRJE, Faculty of Economics, University of Tokyo.
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    8. Andrea Pallavicini & Daniele Perini & Damiano Brigo, 2012. "Funding, Collateral and Hedging: uncovering the mechanics and the subtleties of funding valuation adjustments," Papers 1210.3811, arXiv.org, revised Dec 2012.
    9. Niall Coffey & Warren B. Hrung & Asani Sarkar, 2009. "Capital constraints, counterparty risk, and deviations from covered interest rate parity," Staff Reports 393, Federal Reserve Bank of New York.
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    Cited by:

    1. Alessandro Gnoatto & Nicole Seiffert, 2020. "Cross Currency Valuation and Hedging in the Multiple Curve Framework," Papers 2001.11012, arXiv.org, revised Mar 2021.
    2. Martino Grasselli & Andrea Mazzoran & Andrea Pallavicini, 2024. "A general framework for a joint calibration of VIX and VXX options," Annals of Operations Research, Springer, vol. 336(1), pages 3-26, May.
    3. Alessio Calvelli, 2022. "No-Arbitrage Pricing, Dynamics and Forward Prices of Collateralized Derivatives," Papers 2208.08746, arXiv.org, revised Jun 2024.
    4. Emanuele Nastasi & Andrea Pallavicini & Giulio Sartorelli, 2020. "Smile Modeling In Commodity Markets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 23(03), pages 1-28, May.

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