Wednesday, August 25, 2010

Discounting Revisited: Valuations under funding costs, counterparty risk and collateralization

by Christian P. Fries of DZ Bank AG

We present two different valuations. The first is a mark-to-market valuation which determines the liquidation value of a product. It does, buy construction, exclude any funding cost. The second is a portfolio valuation which determines the replication value of a product including funding costs.

We will also consider counterparty risk. If funding costs are presents, i.e., if we value a portfolio by a replication strategy then counterparty risk and funding are tied together:
  • In addition to the default risk with respect to our exposure we have to consider the loss of a potential funding benefit, i.e., the impact of default on funding.
  • Buying protection against default has to be funded itself and we account for that.
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