Adapting the CVA model to Leland's framework

TL;DR

This paper extends the CVA model within Leland's framework by incorporating transaction costs, deriving a nonlinear PDE, proving solution existence, and analyzing the impact of various risk factors on option pricing.

Contribution

It introduces a transaction cost component into the CVA model, derives a nonlinear PDE, and develops a numerical scheme for solution analysis.

Findings

Derived a nonlinear PDE with transaction costs

Proved existence of solutions for the PDE

Analyzed the impact of risk factors on option prices

Abstract

We consider the framework proposed by Burgard and Kjaer (2011) that derives the PDE which governs the price of an option including bilateral counterparty risk and funding. We extend this work by relaxing the assumption of absence of transaction costs in the hedging portfolio by proposing a cost proportional to the amount of assets traded and the traded price. After deriving the nonlinear PDE, we prove the existence of a solution for the corresponding initial-boundary value problem. Moreover, we develop a numerical scheme that allows to find the solution of the PDE by setting different values for each parameter of the model. To understand the impact of each variable within the model, we analyze the Greeks of the option and the sensitivity of the price to changes in all the risk factors.