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Behavioral Value Adjustments

Author

Listed:
  • MATTEO BISSIRI

    () (Cassa Depositi e Prestiti S.p.a., Rome, Italy)

  • RICCARDO COGO

    () (Cassa Depositi e Prestiti S.p.a., Rome, Italy)

Abstract

Assets or liabilities with embedded prepayment/extension options can be subject to behavioral risk, due to the unpredictable exercise strategy followed by the option holder who does not act purely on the strength of financial convenience. When seen from the viewpoint of the option seller, such behavior results in a lower option value and an additional source of uncertainty in future cash flows. In this paper, we propose a general framework to model behavioral risk by taking advantage of a full parallel with credit portfolio modeling and by combining the features of option-based and intensity models. Our approach is micro-structural, meaning that the aggregate prepayment rate derives from the sum of individual decisions. In principle, a detailed characterization of the behavior of a pool of investors can be performed depending on available data. A particular emphasis is placed on the precise definition of behavioral risk and on the modeling of nonmarket factors, which may contribute significantly to the variance of future cash flows. Finally, we discuss the calibration of a behavioral risk premium and the pricing of contracts with embedded options by introducing the concept of behavioral risk adjustment (βVA), in line with the recent development of XVA methodology.

Suggested Citation

  • Matteo Bissiri & Riccardo Cogo, 2017. "Behavioral Value Adjustments," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(08), pages 1-37, December.
  • Handle: RePEc:wsi:ijtafx:v:20:y:2017:i:08:n:s0219024917500509
    DOI: 10.1142/S0219024917500509
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    References listed on IDEAS

    as
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