CVA and FVA to Derivatives Trades Collateralized by Cash

TL;DR

This paper develops a PDE-based framework combining replication and expectation pricing to evaluate derivatives with cash collateral, incorporating CVA and FVA adjustments, and demonstrates numerical solutions for different collateral scenarios.

Contribution

It introduces a PDE approach that decomposes derivatives prices into risk-free value, CVA, and FVA, with analytical and numerical methods for their evaluation.

Findings

CVA can often be evaluated analytically or semi-analytically.

FVA and derivatives values require recursive numerical solutions.

Numerical examples include equity options and interest-rate swaps with margin revisions.

Abstract

In this article, we combine replication pricing with expectation pricing for derivative trades that are partially collateralized by cash. The derivatives are replicated by underlying assets and cash, using repurchasing agreement (repo) and margining, which incur funding costs. We derive a partial differential equation (PDE) for the derivatives price, obtain and decompose its solution into the risk-free value of the derivative plus credit valuation adjustment (CVA) and funding valuation adjustment (FVA). For most derivatives, as we shall show, CVAs can be evaluated analytically or semi-analytically, while FVAs, as well as the derivatives values, will have to be solved recursively through numerical procedures due to their interdependence. In numerical demonstrations, continuous and discrete margin revisions are considered, respectively, for an equity call option and a vanilla interest-rate swaps.