Funding strategies, funding costs

The economic value of derivatives is influenced by funding costs, because the costs imply windfalls or shortfalls to bondholders on a bank’s default. But the resulting adjustments depend not just on the funding spread but on the funding strategy deployed. It is another layer of complexity to derivatives pricing. By Christoph Burgard and Mats Kjaer

Incorporating the effects of funding derivatives into their pricing has become a hot topic in the past couple of years. Following on from earlier work by Piterbarg (2010), our last paper in Risk (Burgard & Kjaer, 2011b) established how funding costs, funding benefits and counterparty risk could be treated within one framework extending the approach of Black-Scholes-Merton. This showed that if a derivative’s issuer is able to perfectly hedge the risk of its own default, the only adjustment to the