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Risky funding: a unified framework for counterparty and liquidity risk

Morini, Massimo and Prampolini, Andrea (2010): Risky funding: a unified framework for counterparty and liquidity risk.

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Abstract

We analyze the liquidity component in a derivative transaction where both counterparties can default, and the effect of a counterparty's default probability on his funding costs and benefits. The analysis shows that the value of a transaction is influenced not by the total cost of funding of a counterparty, but only by that component of the cost of funding corresponding to his bond-CDS basis spread, and this regulates which trades are possible in the market. Moreover, we find that the DVA can be represented as a funding benefit for the borrower, alternatively to the market standard that considers it a benefit coming from the borrower's own default risk.

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