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A Note on Discounting and Funding Value Adjustments for Derivatives

Han, Meng and He, Yeqi and Zhang, Hu (2013): A Note on Discounting and Funding Value Adjustments for Derivatives.

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Abstract

In this paper, valuation of a derivative partially collateralized in a specific foreign currency defined in its credit support annex traded between default-free counterparties is studied. Two pricing approaches -- by hedging and by expectation -- are presented to obtain the same valuation formulae. Our findings show that the current marking-to-market value of such a derivative consists of three components: the price of the perfectly collateralized derivative (a.k.a. price by collateral rate discounting), the value adjustment due to different funding spreads between the payoff currency and the collateral currency, and the value adjustment due to funding requirements of the uncollateralized exposure. These results generalize previous works on discounting for fully collateralized derivatives and on funding value adjustment for partially collateralized or uncollateralized derivatives.

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