Differential rates, differential prices

Collateral agreements and funding costs affect derivatives prices through discounting and adjustments. But if the borrowing and lending rates aren’t equal, the situation becomes even more complicated. Fabio Mercurio shows that buy and sell prices diverge, and the resulting non-linear valuation means a portfolio may not be the sum of its parts

Collateralisation has a direct impact on the valuation of derivatives. They become similar in spirit to futures, where marking-to-market and settlement occurs daily and not just at the contract’s maturity. Derivatives are marked-to-market, and may have collateral calls, daily. Therefore, classic risk-neutral pricing needs to be revised to take into account collateral features and posting frequency. The move to put a greater proportion of over-the-counter derivatives on to central clearing makes