Arbitrage-Free XVA

TL;DR

This paper introduces a no-arbitrage framework for computing XVA, incorporating funding costs, counterparty risk, and collateralization, using BSDEs and PDEs, with explicit formulas and numerical illustrations.

Contribution

It develops a comprehensive no-arbitrage approach for XVA calculation, deriving BSDEs and PDEs, and provides explicit solutions in symmetric rate cases and numerical analysis for asymmetric rates.

Findings

Explicit XVA formulas when borrowing and lending rates are equal.

Existence of unique classical solutions for the PDEs in asymmetric rate cases.

Numerical results showing the impact of funding costs and counterparty risk on XVA.

Abstract

We develop a framework for computing the total valuation adjustment (XVA) of a European claim accounting for funding costs, counterparty credit risk, and collateralization. Based on no-arbitrage arguments, we derive backward stochastic differential equations (BSDEs) associated with the replicating portfolios of long and short positions in the claim. This leads to the definition of buyer's and seller's XVA, which in turn identify a no-arbitrage interval. In the case that borrowing and lending rates coincide, we provide a fully explicit expression for the unique XVA, expressed as a percentage of the price of the traded claim, and for the corresponding replication strategies. In the general case of asymmetric funding, repo and collateral rates, we study the semilinear partial differential equations (PDE) characterizing buyer's and seller's XVA and show the existence of a unique classical solution to it. To illustrate our results, we conduct a numerical study demonstrating how funding costs, repo rates, and counterparty risk contribute to determine the total valuation adjustment.