Preface to Chapter 1

Chris Kenyon and Andrew Green

Contents

Introduction

Preface to Chapter 1

1.

Being Two-Faced over Counterparty Credit Risk

2.

Risky Funding: A Unified Framework for Counterparty and Liquidity Charges

3.

DVA for Assets

4.

Pricing CDSs’ Capital Relief

5.

The FVA Debate

6.

The FVA Debate: Reloaded

7.

Regulatory Costs Break Risk Neutrality

8.

Risk Neutrality Stays

9.

Regulatory Costs Remain

10.

Funding beyond Discounting: Collateral Agreements and Derivatives Pricing

11.

Cooking with Collateral

12.

Options for Collateral Options

13.

Partial Differential Equation Representations of Derivatives with Bilateral Counterparty Risk and Funding Costs

14.

In the Balance

15.

Funding Strategies, Funding Costs

16.

The Funding Invariance Principle

17.

Regulatory-Optimal Funding

18.

Close-Out Convention Tensions

19.

Funding, Collateral and Hedging: Arbitrage-Free Pricing with Credit, Collateral and Funding Costs

20.

Bilateral Counterparty Risk with Application to Credit Default Swaps

21.

KVA: Capital Valuation Adjustment by Replication

22.

From FVA to KVA: Including Cost of Capital in Derivatives Pricing

23.

Warehousing Credit Risk: Pricing, Capital and Tax

24.

MVA by Replication and Regression

25.

Smoking Adjoints: Fast Evaluation of Monte Carlo Greeks

26.

Adjoint Greeks Made Easy

27.

Bounding Wrong-Way Risk in Measuring Counterparty Risk

28.

Wrong-Way Risk the Right Way: Accounting for Joint Defaults in CVA

29.

Backward Induction for Future Values

30.

A Non-Linear PDE for XVA by Forward Monte Carlo

31.

Efficient XVA Management: Pricing, Hedging and Allocation

32.

Accounting for KVA under IFRS 13

33.

FVA Accounting, Risk Management and Collateral Trading

34.

Derivatives Funding, Netting and Accounting

35.

Managing XVA in the Ring-Fenced Bank

36.

XVA: A Banking Supervisory Perspective

37.

An Annotated Bibliography of XVA

In “Being two-faced over counterparty credit risk” (Gregory 2009) the main, and highly influential, result was that the credit value adjustment (CVA) calculated by one counterparty was exactly the debt value adjustment calculated by the other counterparty. This result was widely applauded as preserving symmetry in pricing. In his conclusion, Jon Gregory identifies the key concern about bilateral counterparty risk: “should, therefore, an institution post profits linked to their own worsening credit quality?”. This concern was also widely echoed going forward.

This paper provoked the question of whether symmetry was actually present when there were funding costs as well as default risk. This leads to Chapter 2, “Risky funding with counterparty and liquidity charges” (Morini and Prampolini 2011), where the intuition of asymmetry and funding is developed.

A further refinement came with the realisation that if only derivatives are considered and if the focus is changed from own-credit spread to own-funding costs, then this can be, and is, routinely monetised by institutions that are short cash, ie, most banks, because funding benefits reduce borrowing requirements (see Chapter 15

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