Illustrating a Problem in the Self-Financing Condition in Two 2010-2011 Papers on Funding, Collateral and Discounting

Abstract

We illustrate a problem in the self-financing condition used in the papers beyond discounting: collateral agreements and derivatives pricing (Risk Magazine, February 2010) and Partial Differential Equation Representations of Derivatives with Counterparty Risk and Funding Costs (The Journal of Credit Risk, 2011). These papers state an erroneous self-financing condition. In the first paper, this is equivalent to assuming that the equity position is self-financing on its own and without including the cash position. In the second paper, this is equivalent to assuming that a subportfolio is self-financing on its own, rather than the whole portfolio. The error in the first paper is avoided when clearly distinguishing between price processes, dividend processes and gain processes. We present an outline of the derivation that yields the correct statement of the self-financing condition, clarifying the structure of the relevant funding accounts, and show that the final result in beyond discounting is correct, even if the self-financing condition stated is not.