The Effects of Credit Risk and Funding on the Pricing of Uncollateralized Derivative Contracts

Abstract

In the aftermath of the global financial crisis of 2007-2008, regulators sought to promote transparency and reduce systemic risk in the previously unregulated market for over-the-counter (OTC) financial derivative contracts. The resulting legislation subjects many market participants to mandatory central clearing and margin requirements for previously non-cleared derivatives. Recently, however, the Board of Governors of the Federal Reserve system and the Commodity Futures Trading Commission re-proposed rules that would provide exemptions for certain commercial end-users who are not “financial entities” and who implement financial derivatives strategies in order “to hedge or mitigate commercial risk”. Exempt firms that transact OTC derivative contracts would not be subject to the mandatory central clearing and margin requirements, or to competitive trade execution. Not surprisingly, many commercial end-users welcomed this news, since they would not be required to comply with these often costly stipulations. Banks are subject to higher capital charges for uncollateralized trades and typically incorporate the cost of counterparty credit risk into the prices of derivative contracts quoted to commercial end-users. Many banks have adopted a framework under which they incorporate the cost of funding and liquidity into the risk-neutral price of uncollateralized derivative contracts. The purpose of this paper is to outline the effects of counterparty credit risk, one’s own credit risk and funding costs on the pricing of uncollateralized financial derivative contracts. We examine Credit Valuation Adjustment (CVA), Debit Valuation Adjustment (DVA) and Funding Valuation Adjustment (FVA), which are collectively referred to as XVA.