Risky Funding: A Unified Framework for Counterparty and Liquidity Charges

Massimo Morini and Andrea Prampolini

The pricing of funding liquidity and the pricing of counterparty credit risk are closely related. Companies usually compute a spread for funding costs that includes a compensation for their own risk of default. However, interactions between the two are still poorly understood, while banks are in need of a sound framework to underpin consistent policies for charging funding and credit costs. In this chapter we try to provide the cornerstones of a unified consistent framework for liquidity and credit risk adjustments that can help banks in this process.

We first argue that a naive application of the standard approach to including funding costs by modifying the discounting rate, when it is put in place together with the standard approach for the computation of credit value adjustment (CVA) and debt value adjustment (DVA) leads to double-counting of assets that can be realised only once. Here we show how this issue can be avoided. We devise a practical and general approach to the problem by taking explicitly into account, in the valuation of a derivative, the funding strategy that needs to be put in place to manage the liquidity absorbed or generated by the derivative, and we study