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A Second Look at Post Crisis Pricing of Derivatives - Part I: A Note on Money Accounts and Collateral

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  • Tumasyan, Hovik

Abstract

The paper reviews origins of the approach to pricing derivatives post-crisis by following three papers that have received wide acceptance from practitioners as the theoretical foundations for it - [Piterbarg 2010], [Burgard and Kjaer 2010] and [Burgard and Kjaer 2013]. The review reveals several conceptual and technical inconsistencies with the approaches taken in these papers. In particular, a key component of the approach - prescription of cost components to a risk-free money account, generates derivative prices that are not cleared by the markets that trade the derivative and its underlying securities. It also introduces several risk-free positions (accounts) that accrue at persistently non-zero spreads with respect to each other and the risk free rate. In the case of derivatives with counterparty default risk [Burgard and Kjaer 2013] introduces an approach referred to as semi-replication, which through the choice of cost components in the money account results in derivative prices that carry arbitrage opportunities in the form of holding portfolio of counterparty's bonds versus a derivative position with it. This paper derives no-arbitrage expressions for default-risky derivative contracts with and without collateral, avoiding these inconsistencies. It will be followed by a part two paper that deals with the derivation of XVA expressions based on the approach in this paper.

Suggested Citation

  • Tumasyan, Hovik, 2018. "A Second Look at Post Crisis Pricing of Derivatives - Part I: A Note on Money Accounts and Collateral," MPRA Paper 90806, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:90806
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    References listed on IDEAS

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    1. Damiano Brigo & Massimo Morini, 2010. "Dangers of Bilateral Counterparty Risk: the fundamental impact of closeout conventions," Papers 1011.3355, arXiv.org.
    2. Andrew Green & Chris Kenyon, 2014. "MVA: Initial Margin Valuation Adjustment by Replication and Regression," Papers 1405.0508, arXiv.org, revised Jan 2015.
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    More about this item

    Keywords

    Financial crisis; collateral; derivatives; XVA; no-arbitrage pricing; counterparty default;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G19 - Financial Economics - - General Financial Markets - - - Other
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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