Arbitrage-Free Pricing Of Derivatives In Nonlinear Market Models

TL;DR

This paper develops a comprehensive framework for arbitrage-free pricing of derivatives considering funding costs, credit risk, and market frictions, extending nonlinear pricing models to more realistic market conditions.

Contribution

It extends existing nonlinear pricing models to incorporate funding costs, credit risk, and market frictions, providing a more realistic valuation framework.

Findings

Extended nonlinear pricing approach to include funding costs and credit risk.

Derived conditions for arbitrage-free pricing in complex market settings.

Provided a unified framework applicable to various market frictions.

Abstract

The objective of this paper is to provide a comprehensive study no-arbitrage pricing of financial derivatives in the presence of funding costs, the counterparty credit risk and market frictions affecting the trading mechanism, such as collateralization and capital requirements. To achieve our goals, we extend in several respects the nonlinear pricing approach developed in El Karoui and Quenez (1997) and El Karoui et al. (1997), which was subsequently continued in Bielecki and Rutkowski (2015).