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**Valuations under Funding Costs, Counterparty Risk and
**

Collateralization.

Christian P. Fries

email@christian-fries.de

May 30, 2010

(First Version: May 15, 2010)

Version 0.9.12

Abstract

Looking at the valuation of a swap when funding costs and counterparty risk are

neglected (i.e., when there is a unique risk free discounting curve), it is natural to ask

“What is the discounting curve of a swap in the presence of funding costs, counterparty

risk and/or collateralization”.

In this note we try to give an answer to this question. The answer depends on who

you are and in general it is “There is no such thing as a unique discounting curve (for

swaps).” Our approach is somewhat “axiomatic”, i.e., we try to make only very few

basic assumptions. We shed some light on use of own credit risk in mark-to-market

valuations, giving that the mark-to-market value of a portfolio increases when the

owner’s credibility decreases.

We presents two different valuations. The ﬁrst is a mark-to-market valuation which

determines the liquidation value of a product. It does, buy construction, exclude any

funding cost. The second is a portfolio valuation which determines the replication value

of a product including funding costs.

We will also consider counterparty risk. If funding costs are presents, i.e., if we

value a portfolio by a replication strategy then counterparty risk and funding are tied

together:

• In addition to the default risk with respect to our exposure we have to consider

the loss of a potential funding beneﬁt, i.e., the impact of default on funding.

• Buying protection against default has to be funded itself and we account for that.

Acknowledgment

I am grateful to Christoph Kiehn, Jörg Kienitz, Matthias Peter, Marius Rott, Oliver

Schweitzer and Jörg Zinnegger for stimulating discussions.

1

Discounting Revisited Christian Fries

Contents

1 Introduction 4

1.1 Two Different Valuations . . . . . . . . . . . . . . . . . . . . . . . . 4

1.2 Related Works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

2 Discounting Cash Flows: The Third Party (Mark-to-Market) Liquidation

View 6

2.1 Discount Factors for Outgoing and Incoming Cash Flows . . . . . . . 6

2.1.1 Valuation of a Fixed Coupon Bond . . . . . . . . . . . . . . . 6

2.2 Counterparty Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.2.1 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.3 Netting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2.4 Valuation of Stochastic Cash Flows . . . . . . . . . . . . . . . . . . . 8

2.4.1 Example: A simple approach to construct a multi-curve model 8

2.5 Credit Linking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

2.5.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

2.6 Collateralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2.6.1 Interpretation . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.6.2 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.6.3 Full Bilateral Collateralization . . . . . . . . . . . . . . . . . 12

3 Discounting Cash Flows: The Hedging View 13

3.1 Moving Cash Flow through Time . . . . . . . . . . . . . . . . . . . . 13

3.1.1 Moving Positive Cash to the Future . . . . . . . . . . . . . . 14

3.1.2 Moving Negative Cash to the Future . . . . . . . . . . . . . . 14

3.1.3 Hedging Negative Future Cash Flow . . . . . . . . . . . . . . 14

3.1.4 Hedging Positive Future Cash Flow . . . . . . . . . . . . . . 14

3.2 Construction of Forward Bonds . . . . . . . . . . . . . . . . . . . . . 14

3.2.1 Forward Bond 1: Hedging Future Incoming Cash with Outgo-

ing Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

3.2.2 Forward Bond 2: Hedging Future Outgoing Cash with Incom-

ing Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

3.2.3 Forward Bond 1’: Hedging Future Credit Linked Incoming

Cash with Credit Linked Outgoing Cash . . . . . . . . . . . . 15

3.2.4 Price of Counterparty Risk Protection . . . . . . . . . . . . . 16

3.2.5 Example: Expressing the Forward Bond in Terms of Rates . . 16

3.2.6 Interpretation: Funding Cost as Hedging Costs in Cash Flow

Management . . . . . . . . . . . . . . . . . . . . . . . . . . 17

3.3 Valuation with Hedging Costs in Cash ﬂow Management (Funding) . 17

3.3.1 Interest for Borrowing and Lending . . . . . . . . . . . . . . 18

3.3.2 From Static to Dynamic Hedging . . . . . . . . . . . . . . . 18

3.3.3 Valuation of a Single Product including Cash Flow Costs . . . 19

3.3.4 Valuation within a Portfolio Context - Valuing Funding Beneﬁts 19

3.4 Valuation with Counterparty Risk and Funding Cost . . . . . . . . . . 20

3.4.1 Static Hedge of Counterparty Risk in the Absence of Netting . 20

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3.4.2 Dynamic Hedge of Counterparty Risk in the Presence of Netting 21

3.4.3 Interpretation . . . . . . . . . . . . . . . . . . . . . . . . . . 23

3.4.4 The Collateralized Swap with Funding Costs . . . . . . . . . 23

4 The Relation of the Different Valuations 23

4.1 One Product - Two Values . . . . . . . . . . . . . . . . . . . . . . . 24

4.2 Valuation of a Bond . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

4.2.1 Valuation of a Bond at Mark-To-Market . . . . . . . . . . . . 25

4.2.2 Valuation of a Bond at Funding . . . . . . . . . . . . . . . . 25

4.3 Convergence of the two Concepts . . . . . . . . . . . . . . . . . . . 25

5 Credit Valuation Adjustments 26

6 Modeling and Implementation 27

7 Conclusion 28

References 29

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1 Introduction

Looking at the valuation of a swap when funding costs and counterparty risk are

neglected (i.e., when there is a unique risk free discounting curve), it is natural to ask

“What is the discounting curve of a swap in the presence of funding costs, counterparty

risk and/or collateralization”.

The answer depends on who you are and how we value. Factoring in funding costs

the answer to that question is “There is no such thing as a unique discounting curve (for

swaps).”

1.1 Two Different Valuations

In Section 2 we will ﬁrst take a simpliﬁed view in valuing claims and cash ﬂows: We

view the market price of a zero coupon bond as the value of a claim and value all claims

according to such zero coupon bond prices. However, this is only one point of view.

We could call it the third party (mark-to-market) liquidation view which is to ask what

is the value of a portfolio of claims if we liquidate it today. This approach does not

value funding cost.

In Section 3 we will then construct a different valuation which includes the funding

costs of net cash requirements. These funding costs occur over the life time of the

product. They are of course not present if the portfolio is liquidated. This alternative

valuation will also give an answer to an otherwise puzzling problem: In the mark-to-

market valuation it appears that the value of the portfolio increases if its credit rating

decreases (because liabilities are written down). However, if we include the funding

cost, then the effect is reversed since funding costs are increased, and since we are not

liquidating the portfolio we have to factor them in.

The difference of the two valuations is their point of view. Liquidating a portfolio

we value it from “outside” as a third party. Accounting for operational cost we value it

from the “inside”. The two parties come to different values because of a very simple

fact: We cannot short sell our own bond (sell protection on our self). However, a third

party can do.

1.2 Related Works

The backward algorithm to valuate under different curves for borrowing and lending

was already given in the textbook [4]. Some of our examples below (e.g., the multi-

curve model using determinstic default intensities in Section 2.4.1) were also taken

from this book.

The usual setup of other papers discussing “multiple” curves is to consider a two or

three curve valuation framework: one (forward) curve for the indices (forward rates

and swap rates), one (discounting) curve for collateralized deals and one (discounting)

curve for funded deals, see, e.g., [1, 9]. However, as we will illustrate, funding cost

and netting agreements may imply that there is no such thing as a product independent

discounting curve.

Piterbarg [8] discusses the effects of the correlation term induced by a mismatch

of the index and the discounting curve, i.e., convexity adjustments. Those convexity

adjustment are reﬂected by our (numerical) valuation algorithm once corresponding

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assumptions (e.g., correlations of rates and spreads) are introduced into the underlying

model.

1

The formulas derivend in [8] are of great importnance since they can be used

to provide efﬁcient approximations for a multi-curve model’s calibration products.

For the modeling of rates (e.g., through basis swap spreads) see, e.g., [5].

In [7] Morini and Prampolini cosidered a zero coupon bond together with its

funding and counterparty risk. They showed that, for a zero coupon, the mark-to-market

valuation including own credit can be re-interpreted as a funding beneﬁt. However,

there argument relies on the fact that there is a premium payed which can be factored in

as a funding beneﬁt, i.e., they consider the liquidation or inception of the deal (i.e., they

consider a mark-to-market valuation). Doing so, the premium payed for a future liability

can always function as funding, hence funding cost beyond the bond-cds basis do not

occure. Our approach is more general in the sense that we consider the true net cash

position. The net cash position will give rise to a complex disocunting algorithm, where

a funding beneﬁt may or may not occure (in a stochastic way). Morini and Prampolini

clarify the relation of the so called bond-cds-basis, i.e. the difference between bond

spread and cds spread. In theory a defaultable bond for which one buys protection

should equal a non defaultable bond as long as the protection itself cannot default.

However, market prices often do not reﬂect that situation, which is attributed to liquidity

aspects of the products. See also the short comment after equation (2).

For the valuation of CVAs using the modeling of default times / stopping times to

value the contract under default see [2] and Section 8 in [6]. In the latter a homogeneity

assumption is made resulting in P

A

(T; t) = P

B

(T; t). In contrast to the CVA approach

modeling default times we considered market prices of zero coupon bonds only and

the valuation would require a model of the zero coupon bond process (one way is to

modeling default times, another is to model spreads and survival probabilities). With

the possible exception of the Section 6 on “Modeling” we did not explicitly model the

impact of liquidity or default risk.

1

Our presentation is essntially “model free”.

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2 Discounting Cash Flows: The Third Party (Mark-to-Market)

Liquidation View

Let us ﬁrst take the point of view of being a third party and value claims between

to other entities A and B. We lay the foundation of discounting, which is given by

considering a single ﬁnancial product: the zero coupon bond. Discounting, i.e., discount

factors are given by the price at which a zero coupon bond can be sold or bought. Let

us formalize this set up:

2.1 Discount Factors for Outgoing and Incoming Cash Flows

Assume entity A can issue a bond with maturity T and notional 1. By this we mean

that A offers the ﬁnancial product which offers the payment of 1 in time T. Let us

denote the time t market price of this product by P

A

(T; t). This is the value at which

the market is willing to buy or sell this bond.

Likewise let P

B

(T; t) denote the price at which the market is willing to buy or sell

bonds issued by some other entity B.

Assume that A receives a cash ﬂow C(T) > 0 from entity B. This corresponds to

A holding a zero coupon bond from entity B having notional C(T) and maturity T.

Hence, the time T value of this isolated cash ﬂow is C(T)P

B

(T; T) (seen from A’s

perspective). Given that C(T) is not stochastic, the time t < T value of this isolated

cash ﬂow then is C(T)P

B

(T; t). We will call this cash ﬂow “incoming”, however we

want to stress that we view ourself as a third party independent of A and B trading in

bonds. Thus we have: P

B

(T; t) is the discount factor of all incoming cash ﬂows from

entity B.

Consider some other contract featuring a cash ﬂow C(T) > 0 fromA to B at time T.

The time T value of this cash ﬂow is −C(T)P

A

(T; T), where we view the value from

A’s perspective, hence the minus sign. We will call this cash ﬂow outgoing, however we

want to stress again that view ourself as a third party independent of A and B trading in

bonds. Given that C(T) is not stochastic, the time t < T value of this isolated cash ﬂow

then is C(T)P

A

(T; t). Thus we have: P

A

(T; t) is the discount factor of all outgoing

cash ﬂows of entity A.

Since we view ourself as a third party, we have that in this framework the discount

factor of a cash ﬂow is determined by the value of the zero coupon bonds of the

originating entity.

If we view a cash ﬂow |C(T)| between A and B from the perspective of the entity

A such that C(T) > 0 means that the cash ﬂow is incoming (positive value for A) and

C(T) < 0 means that the cash ﬂow is outgoing, then its time T value can be written as

min(C(T), 0) P

A

(T; T) + max(C(T), 0) P

B

(T; T).

2.1.1 Valuation of a Fixed Coupon Bond

The knowledge of the discount factors allows the valuation of a ﬁxed coupon bond,

because here all future cash ﬂows have the same origin.

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2.2 Counterparty Risk

The price P

A

(T; t) contains the time-value of a cash ﬂow from A (e.g., through a risk

free interest rate) and the counterparty risk of A.

Usually we expect

0 ≤ P

A

(T; T) ≤ 1,

and due to A’s credit risk we may have P

A

(T; T, ω) < 1 for some path ω. As a

consequence, we will often use the symbol P

A

(T; T) which would not be present if

counterparty risk (and funding) would have been neglected.

In Section 2.6 we will see a case where P

A

C

(T; T, ω) > 1 will be meaningful for

some “virtual” entity A

C

, namely for over-collateralized cash ﬂows from A.

2.2.1 Example

If we do not consider “recoveries” then P

A

(T; T, ω) ∈ {0, 1}. For example, if entity A

defaults in time τ(ω), then we have that P

A

(T; t, ω) = 0 for t > τ(ω).

2.3 Netting

Let us now consider that entity A and B have two contracts with each other: one

resulting in a cash ﬂow from A to B. The other resulting in a cash ﬂow from B to A.

Let us assume further that both cash ﬂow will occur at the same future time T. Let

C

A

(T) > 0 denote the cash ﬂow originating from A to B. Let C

B

(T) > 0 denote the

cash ﬂow originating from B to A. Individually the time T value of the two contracts is

−C

A

(T) P

A

(T; T) and +C

B

(T) P

B

(T; T),

where the signs stem from considering the value from A’s perspective. From B’s

perspective we would have the opposite signs. If C

A

(T) and C

B

(T) are deterministic,

then the time t value of these cash ﬂows is

−C

A

(T) P

A

(T; t) and +C

B

(T) P

B

(T; t),

respectively.

However, if we have a netting agreement, i.e., the two counter parties A and B agree

that only the net cash ﬂow is exchanged, then we effectively have a single contract with

a single cash ﬂow of

C(T) := −C

A

(T) +C

B

(T).

The origin of this cash ﬂow is now determined by its sign. If C(T) < 0 then |C(T)|

ﬂows from A to B. If C(T) > 0 then |C(T)| ﬂows from B to A. The time T value of

the netted cash ﬂow C(T), seen from A’s perspective, is

min(C(T), 0) P

A

(T; T) + max(C(T), 0) P

B

(T; T).

Note that if

P

A

(T; t) = P

B

(T; t) =: P(T; t)

then there is no difference between the value of a netted cash ﬂow and the sum the

individual values, but in general this property does not hold.

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2.4 Valuation of Stochastic Cash Flows

If cash ﬂows C(T) are stochastic, then we have to value their time t value using a

valuation model, e.g., risk neutral valuation using some numeraire N and a correspond-

ing martingale measure Q

N

. The analytic valuation (which actually stems from a

static hedge) as C(T)P

A

(T; t) no longer holds. Let N denote a numeraire and Q

N

a

corresponding martingale measure, such that,

P

A

(T; t)

N(t)

= E

Q

N

P

A

(T; T)

N(T)

|F

t

.

Then a possibly stochastic cash ﬂow C(T), outgoing from A is evaluated in the usual

way, where the value is given as

E

Q

N

C(T) P

A

(T; T)

N(T)

|F

t

**Note that the factor P
**

A

(T; T) determines the effect of the origin of the cash ﬂow, here

A. In theories where counterparty risk (and funding) is neglected, the cash ﬂow C(T) is

valued as

E

Q

N

C(T)

N(T)

|F

t

.

2.4.1 Example: A simple approach to construct a multi-curve model

A simple approach to include counterparty risk, i.e., different discounting curves, into a

standard single curve interest rate model is by assuming a deterministic default intensity.

To formalize this, let F

t

denote the ﬁltration including counterparty risk and assume

that

F

t

= G

t

×H

t

,

where G

t

is the ﬁltration associated with our given the counterparty risk-free model. In

other words, we assume that default free payoffs are valued as

P(T; t) = N(t) E

Q

N

1

N(T)

F

T

= N(t) E

Q

N

1

N(T)

G

T

**and we implicitly deﬁne the counterparty risk as
**

P

A

(T; t) = N(t) E

Q

N

P

A

(T; T)

N(T)

F

T

= N(t) E

Q

N

1

N(T)

G

T

P

A

(t; t) exp

−

T

t

λ

A

(τ) dτ

= P(T; t) P

A

(t; t) exp

−

T

t

λ

A

(τ) dτ

.

So in other words, every time T cashﬂow has to carry a marker P

A

(T; T) which

identiﬁes its counterparty (source), here A. The time t valuation of this cashﬂow, i.e.,

the numeraire relative conditional expectation of the cashﬂow, is given by the contitional

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expectation of the corresponding counterparty risk-free cashﬂow (i.e., with respect to

the ﬁltration G of the single curve model) times the survival probablity times a new

marker P

A

(t; t). Obviously, the process P

A

(T) is a Q

N

-martingale (with respect to

the full ﬁlration F. Note that the default event, i.e., the ﬁltration H, is not modelled at

all. The assumption that the default intensity λ is deterministic is sufﬁcient to value the

default indicator function. See also Chapter 28 in [4].

Note that such a model does not explicitly distinguish liquiditiy effects and default

risk effects. They are all subsummed in the market implied default intensity λ.

2.5 Credit Linking

Let us consider a bond P

C

(T; t) issued by entity C. Let us consider a contract where

A pays P

C

(T; T) in t = T, i.e., A pays 1 only if C survived, otherwise it will pay C’s

recovery. However, this cash ﬂow still is a cash ﬂow originating (granted) by A. The

time T value of this cash ﬂow is P

C

(T; T)P

A

(T; T).

This contract can been seen as a credit linked deal.

2.5.1 Examples

If P

C

(T; T, ω) = 1 for all ω ∈ Ω, then P

C

has no credit risk. In this case we have

N(t)E

Q

N

P

C

(T; T)P

A

(T; T)

N(T)

| F

t

= P

A

(T; t).

Also, If P

C

(T; T, ω) = P

A

(T; T, ω) ∈ {0, 1} for all ω ∈ Ω, then C defaults if and

only if A defaults and there are no recoveries. In that case we also have

N(t)E

Q

N

P

C

(T; T)P

A

(T; T)

N(T)

| F

t

= P

A

(T; t).

If the two random variables P

A

(T; T) and P

C

(T; T) are independent we have

N(t)E

Q

N

P

C

(T; T)P

A

(T; T)

N(T)

| F

t

= P

C

(T; t) P

A

(T; t)

1

P(T; t)

,

where P(T; t) := N(t)E

Q

N

1

N(T)

| F

t

.

To prove the latter we switch to terminal measure (i.e., choose N = P(T) such that

N(T) = 1) and get

N(t)E

Q

N

P

C

(T; T)P

A

(T; T)

N(T)

| F

t

= N(t) E

Q

N

P

C

(T; T) | F

t

E

Q

N

P

A

(T; T) | F

t

= P

C

(T; t) P

A

(T; t)

1

N(t)

= P

C

(T; t) P

A

(T; t)

1

P(T; t)

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2.6 Collateralization

Collateralization is not some “special case” which has to be considered in the above

valuation framework. Collateralization is an additional contract with an additional

netting agreement (and a credit link). As we will illustrate, we can re-interpret a

collateralized contract as a contract with a different discount curve, however, this is

only a re-interpretation.

For simplicity let us consider the collateralization of a single future cash ﬂow.

Let us assume that counterparty A pays M in time T = 1. Thus, seen from the

perspective of A, there is a cash ﬂow

−MP

A

(T; T) in t = T.

Hence, the time t value of the non-collateralized cash ﬂow is −MP

A

(T; t). Next,

assume that counterparty A holds a contract where an entity C will pay K in time T.

Thus, seen from the the perspective of A there is a cash ﬂow

KP

C

(T; T) in t = T.

Hence, the time t value of this cash ﬂow is KP

C

(T; t).

If we value both contracts separately, then the ﬁrst contract evaluates to −N, the

second contract evaluates to K. If we use the second contract to “collateralize” the ﬁrst

contract we bundle the two contracts in the sense that the second contract is passed to

the counterparty B as a pawn. This can be seen as letting the second contract default if

the ﬁrst contract defaults. The time T value thus is

KP

C

(T; T) −M

P

A

(T; T),

where we assumed that the net cash ﬂow is non-positive, which is the case if K < M

and P

C

(T; T) ≤ 1, so we do not consider over-collateralization. The random variable

P

C

(T; T) accounts for the fact that the collateral may itself default over the time, see

“credit linked” above.

We have

KP

C

(T; T) −M

P

A

(T; T)

= KP

C

(T; T) −MP

A

(T; T) + K

P

C

(T; T)P

A

(T; T) −P

C

(T; T)

**Thus, the difference of the value of the collateralized package and the sum of the
**

individual deals (M −K) is

K

P

C

(T; T)P

A

(T; T) −P

C

(T; T)

.

It is possible to view this change of the value of the portfolio as a change of the

value of the outgoing cash ﬂow. Let us determine the implied zero coupon bond process

P

A

C

such that

−M P

A

C

(T; T)

!

= −M P

A

(T; T)

+K

P

C

(T; T)P

A

(T; T) −P

C

(T; T)

.

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It is

P

A

C

(T; T) := P

A

(T; T) −

K

M

P

C

(T; T)P

A

(T; T) −P

C

(T; T)

. (1)

We refer to P

A

C

as the discount factor for collateralized deals. It should be noted that a

corresponding zero coupon bond does not exist (though it may be synthesized) and that

this discount factor is simply a computational tool. In addition, note that the discount

factor depends on the value (K) and quality (P

C

(T; T)) of the collateral.

2.6.1 Interpretation

From the above, we can check some limit cases:

• For P

C

(T; T)P

A

(T; T) = P

C

(T; T) we ﬁnd that P

A

C

(T; T) = P

A

(T; T).

Note that this equations holds, for example, if P

A

(T; T) < 1 ⇒ P

C

(T; T).

This can be interpreted as: if the quality of the collateral is “less or equal” to the

quality of the original counterpart, then collateralization has no effect.

• For P

C

(T; T)P

A

(T; T) = P

A

(T; T) and 0 ≤ K ≤ M we ﬁnd that P

A

C

(T; T) =

αP

C

(T; T) + (1 − α)P

A

(T; T), where α =

K

M

, i.e., if the collateral does not

compromise the quality of the bond as a credit linked bond, then collateralization

constitutes a mixing of the two discount factors at the ratio of the collateralized

amount.

• For P

C

(T; T)P

A

(T; T) = P

A

(T; T) and K = M we ﬁnd that P

A

C

(T; T) =

P

C

(T; T), i.e., if the collateral does not compromise the quality of the bond as

a credit linked bond and the collateral matches the future cash ﬂow, then the

collateralized discount factor agrees with the discount factor of the collateral.

Given that P

C

(T; T)P

A

(T; T) = P

A

(T; T) we ﬁnd that collateralization has a

positive value for the entity receiving the collateral. The reason can be interpreted in a

funding sense: The interest payed on the collateral is less than the interest payed on an

issued bond. Hence, the entity receiving collateral can save funding costs.

2.6.2 Example

Let us consider entities A and C where

N(t) E

Q

N

P

A

(T; T)

N(T)

|F

t

= exp(−r(T −t)) exp(−λ

A

(T −t))

N(t) E

Q

N

P

C

(T; T)

N(T)

|F

t

= exp(−r(T −t)) exp(−λ

C

(T −t))

and

N(t) E

Q

N

P

C

(T; T) P

A

(T; T)

N(T)

|F

t

= exp(−r(T −t)) exp(−λ

C

(T −t)) exp(−λ

A

(T −t)).

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The ﬁrst two equations could be viewed as a deﬁnition of some base interest rate level r

and the counterparty dependent default intensities λ. So to some extend these equations

are deﬁnitions and do not constitute an assumption. However, given that the base level

r is given, the third equation constitutes and assumption, namely that the defaults of A

and C are independent.

From this we get for the impact of collateralization that

P

A

C

(T; t) = exp(−r(T −t)) exp(−λ

A

(T −t))·

·

1 +

K

M

exp(−λ

C

(T −t))

exp(λ

A

(T −t)) −1

.

Note that for K > M this discount factor could have P

A

C

(T; T) > 1. This would

correspond to the case where the original deal is over-collateralized. We excluded

this case in the derivation and in fact the formula above does not hold in general for

an over-collateralized deal, since we would need to consider the discount factor of

the counterpart receiving the collateral (the the over-collateralized part is at risk now).

Nevertheless, a similar formula can be derived.

2.6.3 Full Bilateral Collateralization

Full bilateral collateralization with collateral having the same discount factor, i.e.,

P

A

C

(T) = P

B

D

(T), will result in a single discounting curve (namely that of the

collateral) regardless of the origin of the cash ﬂow.

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3 Discounting Cash Flows: The Hedging View

We now take a different approach in valuing cash ﬂows and we change our point of

view. We now assume that we are entity A and as a consequence postulate that

Axiom 1: (Going Concern)

Entity A wants to stay in business (i.e., liquidation is not an option) and cash ﬂows

have to be “hedged” (i.e., neutralized, replicated). In order to stay in business, future

outgoing cash ﬂows have to be ensured.

The axiom means that we do not value cash ﬂows by relating them to market

bond prices (the liquidation view). Instead we value future cash ﬂows by trading in

assets such that future cash ﬂows are hedged (neutralized). The costs or proceeds

of this trading deﬁne the value of future cash ﬂows. An entity must do this because

all uncovered negative net cash ﬂow will mean default. Future net (!) cash ﬂow is

undesirable. A future cash ﬂow has to be managed.

This is to some extend reasonable since cash itself is a bad thing. It does not earn

interest. It needs to be invested. We will take a replication / hedging approach to value

future cash. In addition we take a conservative point of view: a liability in the future

(which cannot be neutralized by trading in some other asset (netting)) has to be secured

in order to ensure that we stay in business. Not paying is not an option. This relates to

the “going concern” as a fundamental principle in accounting.

At this point one may argue that a future outgoing cash ﬂow is not a problem. Once

the cash has to ﬂow we just sell an asset. However, then we would be exposed to risk

in that asset. This is not the business model of a bank. A bank hedges its risk and so

future cash ﬂow has to be hedged as well. Valuation is done by valuing hedging cost.

Changing the point of view, i.e., assuming that we are entity A has another conse-

quence, which we also label as an “Axiom”:

Axiom 2:

We cannot short sell our own bond.

The rationale of this is clear: While a third party E actually can short sell a bond

issued by A by selling protection on A, A itself cannot offer such an instrument. It

would offer an insurance on its own default, but if the default occurs, the insurance does

not cover the event. Hence the product is worthless.

3.1 Moving Cash Flow through Time

Axiom 1 requires that we consider transactions such that all future cash ﬂow is converted

into todays cash ﬂow, where then a netting of cash occurres. Axiom 2 then restricts the

means how we can move cash ﬂows around.

Let us explore the means of “moving” cash through time. To illustrate the concept

we ﬁrst consider deterministic cash ﬂows only. These allow for static hedges through

the construction of appropriate forward bonds in Section 3.2. Dynamic hedges will be

considered in Section 3.3.

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Let us assume that there is a risk free entity issuing risk free bonds P

◦

(T; t) by

which we may deposit cash.

2

3.1.1 Moving Positive Cash to the Future

If entity A (i.e., we) has cash N in time t it can invest it and buy bonds P

◦

(T; t). The

cash ﬂow received in T then is N

1

P

◦

(T;t)

.

This is the way by which positive cash can be moved from t to a later time T > t

(risk less, i.e., suitable for hedging). Note that investing in to a bond P

B

(T; t) of some

other entity B is not admissible since then the future cash ﬂow would be credit linked

to B.

3.1.2 Moving Negative Cash to the Future

If entity A (i.e., we) has cash −N in time t it has to issue a bond in order to cover

this cash. In fact, there is no such thing as negative cash. Either we have to sell assets

or issue a bond. Assume for now that selling assets is not an option. Issuing a bond

generating cash ﬂow +N (proceeds) the cash ﬂow in T then is −N

1

P

A

(T;t)

(payment).

This is the way by which negative cash can be moved from t to a later time T > t.

3.1.3 Hedging Negative Future Cash Flow

If entity A (i.e., we) is confronted with a cash ﬂow −N in time T it needs to hedge

(guarantee) this cash ﬂow by depositing −N

1

P

◦

(T;t)

today (in bonds P

◦

(T; t)).

This is the way by which negative cash can be moved from T to an earlier time

t < T.

A remark is in order now: An alternative to net a future outgoing cash ﬂow is by

buying back a corresponding −P

A

(T; t) bond. However, let us assume that buying

back bonds is currently not an option, e.g., for example because there are no such bonds.

Note that due to Axiom 2 it is not admissible to short sell our own bond.

3

3.1.4 Hedging Positive Future Cash Flow

If entity A (i.e., we) is confronted with a cash ﬂow +N in time T it needs to hedge (net)

this cash ﬂow by issuing a bond with proceeds N

1

P

A

(T;t)

today (in bonds P

◦

(T; t)).

This is the way by which positive cash can be moved from T to an earlier time

t < T.

3.2 Construction of Forward Bonds

The basic instrument to manage cash ﬂows will be the forward bond transaction, which

we consider next. To comply with Axiom 2 we simply assume that we can only enter in

one of the following transactions, never sell it. Hence we have to consider two different

forward bonds.

2

Counterparty risk will be considered at a later stage.

3

We will later relax this assumption and allow for (partial) funding beneﬁts by buying back bonds.

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3.2.1 Forward Bond 1: Hedging Future Incoming Cash with Outgoing Cash

Assume we haven an incoming cash ﬂow M from some counterparty risk free entity to

entity A in time T

2

and an outgoing cash ﬂow cash ﬂow −N from entity A (i.e., we) to

some other entity in time T

1

. Then we perform the following transactions

• We neutralize (secure) the outgoing cash ﬂow by an incoming cash ﬂow N by

investing −NP

◦

(T

1

; 0) in time 0.

• We net the incoming cash ﬂow by issuing a bond in t = 0 paying back −M,

where we securitize the issued bond by the investment in NP

◦

(T

1

; 0), resulting

in MP

A

(T

2

; 0)

P

◦

(T

1

;0)

P

A

(T

1

;0)

. Note that the issued bond is securitized only over the

period [0, T

1

].

This transaction has zero costs if N = M

P

A

(T

2

;0)

P

A

(T

1

;0)

. Let

P

A

(T

1

, T

2

) :=

P

A

(T

2

)

P

A

(T

1

)

.

3.2.2 Forward Bond 2: Hedging Future Outgoing Cash with Incoming Cash

Assume we haven an outgoing cash ﬂow −M in T

2

and an incoming cash ﬂow N from

some counterparty risk free entity to entity A (i.e., us) in T

1

. Then we perform the

following transactions

• We neutralize (secure) the outgoing cash ﬂow by an incoming cash ﬂow N by

investing −NP

◦

(T

2

; 0) in time t = 0.

• We net the incoming cash ﬂow by issuing a bond in t = 0 paying back −M,

where we securitize the issued bond by the investment in NP(T

2

; 0), resulting in

MP

◦

(T

1

; 0).

This transaction has zero costs if N = M

P

◦

(T

2

;0)

P

◦

(T

1

;0)

. Let

P

◦

(T

1

, T

2

) :=

P

◦

(T

2

)

P

◦

(T

1

)

.

3.2.3 Forward Bond 1’: Hedging Future Credit Linked Incoming Cash with

Credit Linked Outgoing Cash

In the presents of counterparty risk, the construction of the forward bond (discounting

of an incoming cash ﬂow) is a bit more complex. Assume we have an incoming cash

ﬂow M from entity B to entity A in time T

2

. We assume that we can buy protection on

M received from B at −CDS

B

(T

2

; t), where this protection fee is paid in T

2

. Assume

further that we can sell protection on N received from B at CDS

B

(T

1

; t), where this

protection fee is paid in T

1

. Then we repeat the construction of the forward bond with

the net protected amounts M(1 −CDS

B

(T

2

; t)) and N(1 −CDS

B

(T

1

; t)), replacing

M and N in 3.2.1 respectively. In other words we perform the following transactions

• We buy protection on B resulting in a cash ﬂow −MCDS

B

(T

2

; t) in T

2

.

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• We issue a bond to net the T

2

net cash ﬂow M(1 −CDS

B

(T

2

; t)).

• We sell protection on B resulting in a cash ﬂow NCDS

B

(T

1

; t) in T

1

.

• We invest N(1 −CDS

B

(T

1

; t))P

◦

(T

1

; 0) in t to generate a cash ﬂow of N(1 −

CDS

B

(T

1

; t)) in T

1

.

• We collateralized the issued bond using the risk free bond over [0, T

1

] resulting

in proceeds M(1 −CDS

B

(T

2

; t))P

A

(T

2

; 0)

P

◦

(T

1

;0)

P

A

(T

1

;0)

in t.

This transaction has zero costs if N = M

P

A

(T

2

;0)

P

A

(T

1

;0)

1−CDS

B

(T

2

;t)

1−CDS

B

(T

1

;t)

. Let

P

A|B

(T

1

, T

2

) :=

P

A

(T

2

)

P

A

(T

1

)

1 −CDS

B

(T

2

; t)

1 −CDS

B

(T

1

; t)

.

However, while this construction will give us a cash ﬂow in T

1

which is (because

of selling protection) under counterparty risk, netting of such a cash ﬂow will require

more care. We will consider this in Section 3.4, there we apply this construction with

t = T

1

such that selling protection does not apply.

3.2.4 Price of Counterparty Risk Protection

We denote the price of one unit of counterparty risk protection until T

2

as contracted

in t by CDS

B

(T

2

; t). If we do not consider liquidity effects a fair (mark-to-marked)

valuation will give

P

B

(T

2

; t) + CDS

B

(T

2

; t)P

◦

(T

2

; t) = P

◦

(T

2

; t),

where we assume that the protection fee ﬂows in T

2

(and independently of the default

event). This gives

1 −CDS

B

(T

2

; t) =

P

B

(T

2

; t)

P

◦

(T

2

; t)

.

The latter can be interpreted as as a market implied survival probability.

3.2.5 Example: Expressing the Forward Bond in Terms of Rates

If we deﬁne

P

◦

(T

2

; t)

P

◦

(T

1

; t)

=: exp

−

T

2

T

1

r(τ; t)dτ

P

A

(T

2

; t)

P

A

(T

1

; t)

=: exp

−

T

2

T

1

r(τ; t) +s

A

(τ; t)dτ

1 −CDS

B

(T

2

; t)

1 −CDS

B

(T

1

; t)

=: exp

−

T

2

T

1

λ

B

(τ; t)dτ

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Discounting Revisited Christian Fries

then we have

P

A|B

(T

1

, T

2

) = exp

−

T

2

T

1

r(τ; t) +s

A

(τ; t) +λ

B

(τ; t)dτ

(2)

and we see that discounting an outgoing cash ﬂow backward in time by buying the

corresponding forward bonds generates additional costs of exp

−

T

2

T

1

s

A

(τ; t)dτ

**(funding) compared to discounting an incoming cash ﬂow. In addition incoming cash
**

ﬂows carry the counterparty risk by the additional discounting (cost of protection) at

exp

−

T

2

T

1

λ

B

(τ; t)dτ

.

The expression (2) is similar to a corresponding term in [7], except that there

exp

−

T

2

T

1

r(τ; t) +γ

A

(τ; t) +λ

B

(τ; t)dτ

**had been derived, where γ
**

A

is the bond-cds basis (i.e., γ

A

= s

A

−λ

A

). The difference

stems from the fact that [7] always factors in own-credit, which we do not do according

to axiom 1. However, in the end we can arrived at a similar result since the effective

funding required applies only on the net amount (after all netting has been performed).

4

Not that these single time step static hedges do not consider any correlation, e.g.,

the colleation between A’s funding and B’s counterparty risk. This correlation will

come in once we assume a dynamic model for the corresponding rates and consider

dynamic hedges (e.g., in a time-discrete model). We will do so next, in Section 3.3.

3.2.6 Interpretation: Funding Cost as Hedging Costs in Cash Flow Manage-

ment

From the above, we see that moving cash ﬂows around generates costs and the cash ﬂow

replication value of future cash ﬂows will be lower than the portfolio liquidation value

of future cash ﬂow. The difference of the two corresponds to the “operating costs of

managing un-netted cash ﬂows”, which are just the funding costs. Clearly, liquidating

there are no operating cost (so we save them). However these costs are real. If we have

cash lying around we can invest only at a risk free rate, however we fund ourself at a

higher rate. The only way to reduce cash cost is to net them with other cash ﬂows (e.g.

of assets generating higher returns).

3.3 Valuation with Hedging Costs in Cash ﬂow Management (Funding)

The cash ﬂow replication value is now given by the optimal combination of forward

bonds to hedge (replicate) the future cash ﬂow, where nearby cash ﬂows are “netted” as

good a possible. This is given by a backward algorithm, discounting each cash ﬂow

according to the appropriate forward bond and then netting the result with the next cash

ﬂow.

4

Netting will play an important role how funding and counterparty risk will enter. Note that for the net

exposure we have to net all cashﬂows related to a single counterpart, for the net funding we have to net

all cashﬂows over all counterparts.

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Discounting Revisited Christian Fries

Let us ﬁrst consider the valuation neglecting counter party risk, or, put differently,

all future cash ﬂows exposed to counter party risk have been insured by buying the

corresponding protection ﬁrst (and reducing net the cash ﬂow accordingly). We will

detail the inclusion of counterparty risk in Section 3.4.

3.3.1 Interest for Borrowing and Lending

Obviously, using our two assumptions (Axiom 1 and Axiom 2) we arrived at a very

natural situation. The interest to be paid for borrowing money over a period [T

1

, T

2

] is

(as seen in t)

1

T

2

−T

1

P

A

(T

1

; t)

P

A

(T

2

; t)

−1

,

i.e., our funding rate. The interest earned by depositing money (risk free) over a period

[T

1

, T

2

] is

1

T

2

−T

1

P

◦

(T

1

; t)

P

◦

(T

2

; t)

−1

,

i.e., the risk free rate. Hence we are in a setup where interest for borrowing and lending

are different. The valuation theory in setups when rates for lending and borrowing are

different is well understood, see for example [3].

3.3.2 From Static to Dynamic Hedging

The forward bonds, e.g., P

◦

(T

1

, T

2

; t) or P

A

(T

1

, T

2

; t) deﬁne a static hedge in the

sense that their value is known in t. If we are discounting / hedging stochastic cash

ﬂows C(T) a dynamic hedge is required and C(T

i

)P

A

(T

i−1

, T

i

; T

i−1

) is replaced by

N(T

i−1

) E

Q

N

C(T

i

)P

A

(T

i

; T

i

)

N(T

i

)

.

Note: It is

P

A

(T

i−1

, T

i

; T

i−1

) = P

A

(T

i

; T

i−1

) = N(T

i−1

) E

Q

N

P

A

(T

i

; T

i

)

N(T

i

)

,

i.e., for t = S the forward bond P(S, T; t) is just a bond.

Example: Implementation using Euler simulation of Spreads and Intensities

If we express the bonds in terms of the risk free bond P

◦

, e.g.,

P

A

(T

i

; t)

P

◦

(T

i

; t)

=: exp

−

T

i

T

i−1

s

A

(τ; t)dτ

**and model (!) the process on the right hand side such that s
**

A

(τ; t) is F

T

i−1

-measurable

for t ∈ [T

i−1

, T

i

] (which is usually case if we employ a numerical scheme like the Euler

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scheme for the simulation of spreads s and default intensities λ), then we ﬁnd that for

any cash ﬂow C(T

i

)

N(T

i−1

) E

Q

N

C(T

i

)P

A

(T

i

; T

i

)

N(T

i

)

= N(T

i−1

) E

Q

N

C(T

i

)

N(T

i

)

exp

−

T

i

T

i−1

s

A

(τ; t)dτ

P

A

(T

i−1

; T

i−1

)

and likewise for P

B

.

3.3.3 Valuation of a Single Product including Cash Flow Costs

Let us consider the valuation of a collateralized swap being the only product held by

entity A. Let us assume the swap is collateralized by cash. The package consisting of the

swap’s (collateralized) cash ﬂows and the collateral ﬂows has a mark-to-market value

of zero (valued according to Section 2), by deﬁnition of the collateral. However, the

package represents a continuous ﬂow of cash (margining). If valued using the collateral

curve P

C

= P

◦

these marginal collateral cash ﬂows have mark-to-market value zero

(by deﬁnition of the collateral).

Let us assume that this swap constitutes the only product of entity A and that we

value cash ﬂows by a hedging approach, i.e., dynamically using the two forward bonds

from Section 3.2. Taking into account that for cash we have different interest for

borrowing and lending, the collateral cash ﬂow will generate additional costs. These

are given by the following recursive deﬁnition:

V

d

i

(T

i−1

)

N(T

i−1

)

= E

Q

N

max(X

i

+V

d

i+1

(T

i

), 0)

N(T

i

)

P

A

(T

i

; T

i

)

+

min(X

i

+V

d

i+1

(T

i

), 0)

N(T

i

)

P

◦

(T

i

; T

i

)

F

T

i−1

.

(3)

Here V

d

i+1

(T

i

) is the net cash position required in T

i

to ﬁnance (e.g., fund) the future

cash ﬂows in t > T

i

. X

i

is the collateral margin call occurring in time t = T

i

. Hence

we have to borrow or lend the net amount

V

d

i

(T

i

) = X

i

+V

d

i+1

(T

i

)

over the period (T

i−1

, T

i

]. This amount is then transferred to T

i−1

using the appropriate

forward bond (discounting) for netting with the next margining cash ﬂow X

i−1

.

This is the valuation under the assumption that the X

i

is the net cash ﬂow of entity

A, e.g., as if the collateralized swap is our only product.

3.3.4 Valuation within a Portfolio Context - Valuing Funding Beneﬁts

The situation of Section 3.3.3 now carries over to the valuation of a portfolio of products

hold by entity A. In this the algorithm (3) will determine the discount factor to be used

in the period [T

i−1

, T

i

] from the portfolios net cash position V

d

i

(T

i

), regardless of a

product having an outgoing or incoming cash ﬂow.

Let us discuss a product having a cash ﬂow C(T

i

) in T

i

being part of entity A’s

portfolio resulting in a net (cash) position V

d

i

(T

i

).

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Incoming Cash Flow, Positive Net Position

Given that our net position V

d

i

(T

i

) is positive in T

i

, an incoming (positive) cash ﬂow

C(T

i

) can be factored in at earlier time only by issuing a bond. Hence it is discounted

with P

A

(resulting in a smaller value at t < T

i

, compared to a discounting with P

◦

).

Note that for t > T

i

this cash ﬂow can provide a funding beneﬁt for a future negative

cash ﬂow which would be considered in the case of a negative net position, see 3.3.4).

Outgoing Cash Flow, Positive Net Position

Given that our net position V

d

i

(T

i

) is positive in T

i

, an outgoing (negative) cash ﬂow

C(T

i

) can be served from the positive (net) cash position. Hence it does not require

funding for t < T

i

as long as our net cash position is positive. Factoring in the funding

beneﬁt it is discounted with P

A

(resulting in a larger value at t < T

i

, compared to a

discounting with P

◦

).

Incoming Cash Flow, Negative Net Position

Given that our net position V

d

i

(T

i

) is negative in T

i

, an incoming (positive) cash ﬂow

C(T

i

) reduces the funding cost for the net position. Hence it represents a funding

beneﬁt and is discounted with P

◦

(resulting in a larger value at t < T

i

, compared to a

discounting with P

A

).

Outgoing Cash Flow, Negative Net Position

Given that our net position V

d

i

(T

i

) is negative in T

i

, an outgoing (negative) cash ﬂow

C(T

i

) has to be funded on its own (as long as our net position remains negative).

Hence it is discounted with P

◦

(resulting in a smaller value at t < T

i

, compared to a

discounting with P

A

).

3.4 Valuation with Counterparty Risk and Funding Cost

So far Section 3 did not consider counterparty risk in incoming cash ﬂow. Of course,

it can be included using the forward bond which includes the cost of protection of a

corresponding cash ﬂow.

3.4.1 Static Hedge of Counterparty Risk in the Absence of Netting

Assume that all incoming cash ﬂows from entity B are subject to counterparty risk

(default), but all outgoing cash ﬂow to entity B have to be served. This would be the

case if we consider a portfolio of (zero) bonds only and there is no netting agreement.

Since there is no netting agreement we need to buy protection on each individual

cash ﬂow obtained from B. It is not admissible to use the forward bond P

A|B

(T

1

, T

2

)

to net a T

2

incoming cash ﬂow for which we have protection over [T

1

, T

2

] with a T

1

outgoing (to B) cash ﬂow and then buy protection only on the net amount.

If we assume, for simplicity, that all cash ﬂows X

B

j

i,k

received in T

i

from some

entity B

j

are known in T

0

, i.e., F

T

0

-measurable, then we can attribute for the required

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protection fee in T

0

(i.e., we have a static hedge against counterparty risk) and our

valuation algorithm becomes

V

d

i

(T

i−1

)

N(T

i−1

)

= E

Q

N

max(X

i

+V

d

i+1

(T

i

), 0)

N(T

i

)

P

A

(T

i

; T

i

)

+

min(X

i

+V

d

i+1

(T

i

), 0)

N(T

i

)

P

◦

(T

i

; T

i

)

F

T

i−1

.

(4)

where the time T

i

net cash ﬂow X

i

is given as

X

i

:= X

◦

i

+

¸

j

¸

k

min(X

B

j

i,k

, 0) + (1 −CDS

B

j

(T

i

; T

0

)) max(X

B

j

i,k

, 0)

.

where B

j

denote different counterparties and X

B

j

i,k

is the k-th cash ﬂow (outgoing or

incoming) between us and B

j

at time T

i

. So obviously we are attributing full protection

costs for all incoming cash ﬂows and consider serving all outgoing cash ﬂow a must.

Note again, that in any cash ﬂow X

B

j

i,k

we account for the full protection cost from T

0

to T

i

.

Although this is only a special case we already see that counterparty risk cannot be

separated from funding since (4) makes clear that we have to attribute funding cost for

the protection fees.

5

3.4.2 Dynamic Hedge of Counterparty Risk in the Presence of Netting

However, many contracts feature netting agreements which result in a “temporal netting”

for cash ﬂows exchanged between two counterparts and only the net cash ﬂow carries

the counterparty risk. It appears as if we could then use the forward bond P

A|B

(T

i−1

, T

i

)

and P

B

(T

i−1

, T

i

) on our future T

i

net cash ﬂow and then net this one with all T

i−1

cash

ﬂows, i.e., apply an additional discounting to each netted set of cash ﬂows between two

counterparts. This is not exactly right. Presently we are netting T

i

cash ﬂows with T

i−1

cash ﬂows in a speciﬁc way which attributes for our own funding costs. The netting

agreement between two counterparties may (and will) be different from our funding

adjusted netting. For example, the contract may specify that upon default the close out

of a product (i.e., the outstanding claim) is determined using the risk free curve for

discounting.

Let us denote by V

B

CLSOUT,i

(T

i

) the time T

i

cash being exchanged / being at risk

at T

i

if counterparty B defaults according to all netting agreements (the deals close

out). This value is usually a part of the contract / netting agreement. Usually it will be

a mark-to-market valuation of V

B

at T

i

. One approach to account for the mismatch

is to buy protection over [T

i−1

, T

i

] for the positive part of V

B

CLSOUT,i

(T

i

) (i.e., the

exposure), then additionally buy protection for the mismatch of the contracted default

value V

B

CLSOUT,i

(T

i

) and netted non-default value V

B

i

(T

i

).

5

We assumed that the protection fee is paid at the end of the protection period, it is straight forward to

include periodic protection fees.

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As before let X

B

j

i,k

denote the k-th cash ﬂow (outgoing or incoming) exchanged

between us and entity B

j

at time T

i

. Let

R

B

j

i

(T

i

) :=

¸

k

X

B

j

i,k

+V

B

j

i+1

(T

i

)

denote the value contracted with B

j

, valued in T

i

, including our future funding costs.

Then

V

B

j

i

(T

i

) := R

B

j

i

(T

i

) − p

j

max(R

B

j

i

(T

i

), 0)

. .. .

protection on netted value

including our funding

+p

j

min(V

B

j

CLSOUT,i

(T

i

), 0) −min(R

B

j

i

(T

i

), 0)

. .. .

mismatch of liability

in case of default

is the net value including protection fees over the period [T

i−1

, T

i

], where p

j

is the price

of buying or selling one unit of protection against B

j

over the period [T

i−1

, T

i

], i.e.,

p

j

:= CDS

B

j

(T

i

; T

i−1

).

Let

V

i

(T

i

) :=

¸

j

V

B

j

i

(T

i

).

The general valuation algorithm including funding and counterparty risk is then given

as

V

i

(T

i−1

)

N(T

i−1

)

= E

Q

N

max(V

i

(T

i

), 0)

N(T

i

)

P

A

(T

i

; T

i

)

+

min(V

i

(T

i

), 0)

N(T

i

)

P

◦

(T

i

; T

i

)

F

T

i−1

.

(5)

In our valuation the time T

i−1

value being exposed to entities B

j

counterparty risk is

given by

V

B

j

i

(T

i−1

)

N(T

i−1

)

:= E

Q

N

max(V

i

(T

i

), 0) −max(V

i

(T

i

) −V

B

j

i

(T

i

), 0)

N(T

i

)

P

A

(T

i

; T

i

)

+

min(V

i

(T

i

), 0) −min(V

i

(T

i

) −V

B

j

i

(T

i

), 0)

N(T

i

)

P

◦

(T

i

; T

i

)

F

T

i−1

.

In other words, V

B

j

i

(T

i−1

) is the true portfolio impact (including side effects of funding)

if the ﬂows X

B

j

l,k

, l ≥ i, are removed from the portfolio.

In the case where the mismatch of contracted default value V

B

CLSOUT,i

(T

i

) and

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netted non-default value R

B

j

i

(T

i

) is zero we arrive at

V

B

j

i

(T

i

) := min

R

B

j

i

(T

i

), 0

+ (1 −p

j

) max

R

B

j

i

(T

i

), 0

= R

B

j

i

(T

i

) +p

j

max

R

B

j

i

(T

i

), 0

= R

B

j

i

(T

i

) −p

j

max

R

B

j

i

(T

i

), 0

=

¸

k

X

B

j

i,k

+V

B

j

i+1

(T

i

) −p

j

max

¸

k

X

B

j

i,k

+V

B

j

i+1

(T

i

), 0

.

- in this case we get an additional discount factor on the positive part (exposure) of the

netted value, attributing for the protection costs.

3.4.3 Interpretation

From algorithm (5) it is obvious that the valuation of funding (given by the discounting

using either P

◦

or P

A

) and the valuation of counterparty risk (given by buying/selling

protection at p) cannot be separated. Note that

• We not only account for the default risk with respect to our exposure (V

B

CLSOUT,i

(T

i

)),

but also to the loss of a potential funding beneﬁt, i.e., the impact of default on

funding.

• Buying protection against default has to be funded itself and we account for that.

The algorithms (5) values the so called wrong-way-risk, i.e., the correlation between

counterparty default and couterparty exposure via the term p

j

max(R

B

j

i

(T

i

), 0).

3.4.4 The Collateralized Swap with Funding Costs

Let us consider the collaterlaized swap again. While the mark-to-market value of a

collateralized (secured) cash ﬂow can be calculate off the curve implied by the collateral,

the presents of funding cost changes the picture signiﬁcantly:

• The discount curve determining the collateral may be different from the curve

discount curve attributing for the funding cost. Hence, the collateral will not

match the expected value of the future cashﬂows inclunding funding costs.

• Collateral may require funding or may represent a funding beneﬁt. In case of

default these cashﬂows are lost.

The surprising result is, that the presents of funding cost may introduce counterparty

risk into a collateralize (secured) deal. As a consequence, the collateralized deal has to

be valued within (5) to account for these effects.

4 The Relation of the Different Valuations

Let us summarize the relation of the two different discounting in the presents of

counterparty risk. The mark-to-market value of a time T

i

cash ﬂow is

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cash ﬂow discount factor over [T

i−1

, T

i

]

outgoing (C(T

i

) < 0) P

A

(T

i−1

, T

i

)

incoming (C(T

i

) > 0) P

B

(T

i−1

, T

i

)

In this situation a liability of A is written down, because in case of liquidation of A its

counterparts accepts to receive less than the risk free discounted cash ﬂow today.

The hedging (replication) value of a time T

i

cash ﬂow depends however on our net

cash position, because the net cash position decides if funding cost apply or a funding

beneﬁt can be accounted for. The net cash position has to be determined with the

backward algorithm (3) where each cash ﬂow X

i

is adjusted according to his (netted)

counterparty risk. Using P

B

(T

i

; T

i

)P

◦

(T

i−1

, T

i

) = P

B

(T

i−1

, T

i

) we can formally

write

discount factor over [T

i−1

, T

i

]

cash ﬂow positive net cash in T negative net cash in T

i

outgoing (C(T

i

) < 0) P

A

(T

i−1

, T

i

) P

◦

(T

i−1

, T

i

)

incoming (C(T

i

) > 0) P

B

(T

i

; T

i

)P

A

(T

i−1

, T

i

) P

B

(T

i−1

, T

i

)

The two valuation concepts coincide when P

A

(T

i−1

, T

i

) = P

◦

(T

i−1

, T

i

), i.e., we

do not have funding cost. They also coincide if an outgoing cash ﬂow appears only

in the situation of positive net cash in T

i

(funding beneﬁt) and an incoming cash ﬂow

appears only in the situation of negative net cash T

i

(funding beneﬁt).

Put differently: The liquidation valuation neglects funding by assuming funding

beneﬁts in all possible situations.

6

4.1 One Product - Two Values

Given the valuation framework discussed above a product has at least two values:

• the product can be evaluated “mark-to-marked” as a single product. This value

can be seen as a “fair” market price. Here the product is valued according to

Section 2. This is the product’s idiosyncratic value.

• the product can be evaluated within its context in a portfolio of products owned

by an institution, i.e., including possible netting agreements and operating costs

(funding). This will constitute the value of the product for the institution. Here the

value of the product is given by the change of the portfolio value when the product

is added to the portfolio, where the portfolio is valued with the algorithm (3).

This is the products marginal portfolio value.

However, both valuations share the property that the sum of the values of the products

belonging to the portfolio does not necessarily match the portfolio’s value. This is

clear for the ﬁrst value, because netting is neglected all together. For the second value,

removing the product from the portfolio can change the sign of netted cash ﬂow, hence

change the choice of the chosen discount factors.

6

This is, assuming zero bond-cds basis spread, the situation in [7].

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4.2 Valuation of a Bond

To test our frameworks, lets us go back to the zero coupon bond from which we started

and value it.

4.2.1 Valuation of a Bond at Mark-To-Market

Using the mark-to-market approach we will indeed recover the bonds market value

−P

A

(T; 0) (this is a liability). Likewise for P

B

(T) we get +P

B

(T; 0).

4.2.2 Valuation of a Bond at Funding

Factoring in funding costs it appears as if issuing a bond would generate an instantaneous

loss, because the bond represents a negative future cash ﬂow which has to be discounted

by P

◦

according to the above. This stems from assuming that the proceeds of the issued

bond are invested risk fee. Of course, it would be unreasonable to issue a risky bond

and invest its proceeds risk free.

However, note that the discount factor only depends on the net cash position. If the

net cash position in T is negative, it would be indeed unreasonable to increase liabilities

at this maturity and issue another bond.

Considering the hedging cost approach we get for P

A

(T) the value −P

◦

(T; 0) if

the time T net position is negative. This will indeed represent loss compared to the

mark-to-market value. This indicated that we should instead buy back the bond (or not

issue it at all). If however our cash position is such that this bond represents a funding

beneﬁt (in other words, it is needed for funding), it’s value will be P

A

(T; 0).

For P

B

we get

N(0)E

Q

P

B

(T; T)P

A

(T; T)

N(T)

| F

0

**Assuming that A’s funding and B’s counterparty risk are independent from P
**

◦

(T) we

arrive at

P

B

(T; 0)

P

A

(T; 0)

P

◦

(T; 0)

which means we should sell B’s bond if its return is below our funding (we should not

hold risk free bonds if it is not necessary).

4.3 Convergence of the two Concepts

Not that if A runs a perfect business, securing every future cash ﬂow by hedging

it (using the risk free counterpart P

◦

(T; T)), and if there are no risk in its other

operations, then the market will likely value it as risk free and we will come close to

P

A

(T; T) = P

◦

(T; T). In that case, we ﬁnd that both discounting methods agree and

symmetry is restored.

However, there is even a more closer link between the two valuations. Let us con-

sider that entity A holds a large portfolio of products V

1

, . . . , V

N

. Let V

1

(0), . . . , V

N

(0)

denote the mark-to-market (liquidation) value of those products. Let Π[V

1

, . . . , V

N

](0)

denote the hedging value of the portfolio of those products. If the portfolio’s cash

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ﬂows are hedged in the sense that all future net cash ﬂows are zero, then, neglecting

counterparty risk, we have (approximately)

V

k

(0) ≈ Π[V

1

, . . . , V

N

](0) −Π[V

1

, . . . , V

k−1

, V

k+1

, . . . , V

N

](0).

Thus, the mark-to-market valuation which includes “own-credit” for liabilities corre-

sponds to the marginal cost or proﬁt generated when removing the product from a large

portfolio which includes ﬁnding costs. However, portfolio valuation is non-linear in the

products and hence the sum of the mark-to-market valuation does not agree with the

portfolio valuation with funding costs.

We proof this result only for product consisting of a single cash ﬂow. A linearization

argument shows that it then hold (approximately) for products consisting of many small

cash ﬂows.

If the portfolio is fully hedged the all future cash ﬂows are netted. In other words,

the entity A attributed for all non-netted cash ﬂows by considering issued bonds or

invested money. Then we have V

d

j

(T

j

) = 0 for all j. Let V

k

be a product consisting of

a single cash ﬂow C(T

i

) in T

i

, exchanged with a risk free entity. If this cash ﬂow is

incoming, i.e, C(T

i

) > 0 then removing it the portfolio will be left with an un-netted

outgoing cash ﬂow −C(T

i

), which is according to our rules discounted with P

◦

(T

i

).

Likewise, if this cash ﬂow is outgoing, i.e, C(T

i

) < 0 then removing it the portfolio

will be left with an un-netted incoming cash ﬂow C(T

i

), which is according to our rules

discounted with P

A

(T

i

).

Hence the marginal value of this product corresponds to the mark-to-market valua-

tion.

5 Credit Valuation Adjustments

The valuation deﬁned above includes counter party risk as well as funding cost. Hence,

valuing a whole portfolio using the above valuation, there is no counter party risk

adjustment.

However, the valuation above is computationally very demanding. First, all products

have to be valued together, hence it is not straight forward to look at a single products

behavior without valuing the whole portfolio.

Second, even very simple products like a swap have to be evaluated in a backward

algorithm using conditional expectations in order to determine the net exposure and their

effective funding costs. This is computationally demanding, especially if Monte-Carlo

simulations is used.

As illustrated above, the valuation simpliﬁes signiﬁcantly if all counterparts share

the same zero coupon bond curve P(T; t) and/or the curve for lending an borrowing

agree. A credit valuation adjustment is simply a splitting of the following form

V (t) = V |

P

·

=P

∗(t) + (V (t) −V |

P

·

=P

∗(t))

. .. .

CVA

where V |

P

·

=P

∗(t) denotes the simpliﬁed valuation assuming a single discounting curve

P

∗

(neglecting the origin or collateralization of cash ﬂows).

While the use of a credit valuation adjustment may simplify the implementation of

a valuation system it brings some disadvantages:

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• The valuation using the simpliﬁed single curve, in general, is not correct.

• Hedge parameters (sensitivities) calculated such valuation, in general, are wrong.

In order to cope with this problem we propose the following setup:

• Construction of proxy discounting curve P

∗

such that the CVA is approximately

zero.

• Transfer of sensitivity adjustments calculated from the CVA’s sensitivities.

6 Modeling and Implementation

So far we expressed all valuation in terms of products of cash ﬂows and zero coupon

bond processes like P

A

(T; t). The value of a stochastic time T cash ﬂow C(T)

originating from entity A was given as of time T as

C(T)P

A

(T; T)

and the corresponding time t < T value was expressed using risk neutral valuation

N(0)E

Q

N

C(T)P

A

(T; T)

N(T)

F

0

.

Our presentation was model independent so far. Depending on the cash ﬂow the term

C(T)P

A

(T; T) may give rise to valuation changes stemming from the covariance of

C(T) and

P

A

(T;T)

N(T)

.

For an implementation of the valuation algorithm consider a time discretization

0 =: t

0

< t

1

< · · · < t

n

. We assume that the discretization scheme of the model

primitives models the counterparty risk over the interval [t

i

, t

i+1

) as an F

t

i

-measurable

survival probability such that we have for all t

i+1

cash ﬂows C(t

i+1

) that

N(t

i

)E

Q

N

C(t

i+1

)P

A

(t

i+1

; t

i+1

)

N(t

i

)

F

t

i+1

= N(t

i

)E

Q

N

C(t

i+1

)

N(t

i+1

)

F

t

i

exp

−

t

i+1

t

i

λ

A

(s; t

i

)ds

.

(6)

The expression exp

−

t

i+1

t

i

λ

A

(s; t

i

)ds

**represents an additional “discounting” stem-
**

ming from the issuers credit risk / funding costs. It can be interpreted as and (implied)

survival probability (see Chapter 28 in [4]).

7

Hence any counterparty-risk-free valuation model can be augmented with funding

costs, counterparty risk and collateralization effects by two modiﬁcations:

• The model is augmented by a simulation of the (conditional) one step (forward)

survival probabilities (or funding spreads), e.g., exp

−

t

i+1

t

i

λ

A

(s; t

i

)ds

.

• The valuation is performed using the backward algorithm (3), where in each

time step the survival probabilities and/or funding adjusted discount factors are

applied according to (6).

7

A very simple model is to assume that exp

“

−

R

t

i+1

t

i

λ

A

(s; t

i

)ds

”

is deterministic.

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Discounting Revisited Christian Fries

7 Conclusion

We considered the valuation of cash ﬂows including counterparty risk and funding. We

sheded some light on the own credit risk paradox that the mark-to-market value of a

portfolio increases if its owner’s credibility decreases. After our discussion the situation

now appears much clear: This increase in value is reasonable when considering the

portfolios liquidation since lenders are willing to accept a lower return upon liquidation

in exchange for the increased credit risk.

If we value the portfolio under a hedging perspective (where hedging to some

extend means funding) we see that the portfolio value decreases if its owner’s credibility

decreases. This is also reasonable since funding cost (operating costs) have risen.

The two notion of valuation can co-exist. They do not contradict. One discount-

ing should be used for mark-to-market valuation. The other should be used for risk

management and the governance (managing) of positions.

To see the effect of a single deal on the cash ﬂow management the bank could use a

curve for borrowing and lending and every deal would have to be valuated according to

the algorithm (3).

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Discounting Revisited Christian Fries

References

[1] BIANCHETTI, MARCO:Two Curves, One Price: Pricing & Hedging Interest

Rate Derivatives Using Different Yield Curves for Discounting and Forwarding.

January 2009. http://ssrn.com/abstract=1334356.

[2] BRIGO, DAMIANO; PALLAVICINI, ANDREA; PAPATHEODOROU, VASILEIOS:

Bilateral counterparty risk valuation for interest-rate products: impact of volatil-

ities and correlations. arXiv:0911.3331v3. 2010.

[3] EBMEYER, DIRK: Essays on Incomplete Financial Markets. Doctoral Thesis.

University of Bielefeld, Bielefeld.

[4] FRIES, CHRISTIAN P.: Mathematical Finance. Theory, Modeling, Implementa-

tion. John Wiley & Sons, 2007. ISBN 0-470-04722-4.

http://www.christian-fries.de/finmath/book.

[5] MERCURIO, FABIO: LIBOR Market Models with Stochastic Basis, March

2010.

[6] MORINI, MASSIMO: Solving the puzzle in the interest rate market. 2009.

http://ssrn.com/abstract=1506046.

[7] MORINI, MASSIMO; PRAMPOLINI, ANDREA: Risky funding: a uniﬁed frame-

work for counterparty and liquidity charges. 2010. http://ssrn.com/

abstract=1506046.

[8] PITERBARG, VLADIMIR: Funding beyond discounting: collateral agreements

and derivatives pricing. Risk magazine. February 2010.

[9] WHITTALL, CHRISTOPHER: The price is wrong. Risk magazine. March 2010.

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Discounting Revisited Christian Fries

Notes

Suggested Citation

FRIES, CHRISTIAN P.: Discounting Revisited. Valuation under Funding, Coun-

terparty Risk and Collateralization. (2010).

http://papers.ssrn.com/abstract=1609587.

http://www.christian-fries.de/finmath/discounting

Classiﬁcation

Classiﬁcation: MSC-class: 65C05 (Primary), 68U20, 60H35 (Secondary).

ACM-class: G.3; I.6.8.

JEL-class: C15, G13.

Keywords: Discounting, Valuation, Counterparty Risk, Collateral, Netting, CVA, DVA,

Bond, Swap, Credit Risk, Own Credit Risk, Wrong Way Risk, Liquidity Risk

30 pages. 0 ﬁgures. 0 tables.

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Discounting Revisited

Christian Fries

Contents

1 Introduction 1.1 Two Different Valuations . . . . . . . . . . . . . . . . . . . . . . . . 1.2 Related Works . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Discounting Cash Flows: The Third Party (Mark-to-Market) Liquidation View 2.1 Discount Factors for Outgoing and Incoming Cash Flows . . . . . . . 2.1.1 Valuation of a Fixed Coupon Bond . . . . . . . . . . . . . . . 2.2 Counterparty Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2.1 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 Netting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.4 Valuation of Stochastic Cash Flows . . . . . . . . . . . . . . . . . . . 2.4.1 Example: A simple approach to construct a multi-curve model 2.5 Credit Linking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6 Collateralization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6.1 Interpretation . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6.2 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.6.3 Full Bilateral Collateralization . . . . . . . . . . . . . . . . . 4 4 4

6 6 6 7 7 7 8 8 9 9 10 11 11 12 13 13 14 14 14 14 14 15 15 15 16 16 17 17 18 18 19 19 20 20

3 Discounting Cash Flows: The Hedging View 3.1 Moving Cash Flow through Time . . . . . . . . . . . . . . . . . . . . 3.1.1 Moving Positive Cash to the Future . . . . . . . . . . . . . . 3.1.2 Moving Negative Cash to the Future . . . . . . . . . . . . . . 3.1.3 Hedging Negative Future Cash Flow . . . . . . . . . . . . . . 3.1.4 Hedging Positive Future Cash Flow . . . . . . . . . . . . . . 3.2 Construction of Forward Bonds . . . . . . . . . . . . . . . . . . . . . 3.2.1 Forward Bond 1: Hedging Future Incoming Cash with Outgoing Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.2 Forward Bond 2: Hedging Future Outgoing Cash with Incoming Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.2.3 Forward Bond 1’: Hedging Future Credit Linked Incoming Cash with Credit Linked Outgoing Cash . . . . . . . . . . . . 3.2.4 Price of Counterparty Risk Protection . . . . . . . . . . . . . 3.2.5 Example: Expressing the Forward Bond in Terms of Rates . . 3.2.6 Interpretation: Funding Cost as Hedging Costs in Cash Flow Management . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 Valuation with Hedging Costs in Cash ﬂow Management (Funding) . 3.3.1 Interest for Borrowing and Lending . . . . . . . . . . . . . . 3.3.2 From Static to Dynamic Hedging . . . . . . . . . . . . . . . 3.3.3 Valuation of a Single Product including Cash Flow Costs . . . 3.3.4 Valuation within a Portfolio Context - Valuing Funding Beneﬁts 3.4 Valuation with Counterparty Risk and Funding Cost . . . . . . . . . . 3.4.1 Static Hedge of Counterparty Risk in the Absence of Netting .

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3.4.2 3.4.3 3.4.4

Dynamic Hedge of Counterparty Risk in the Presence of Netting 21 Interpretation . . . . . . . . . . . . . . . . . . . . . . . . . . 23 The Collateralized Swap with Funding Costs . . . . . . . . . 23 23 24 25 25 25 25 26 27 28 29

4 The Relation of the Different Valuations 4.1 One Product - Two Values . . . . . . . . . . . 4.2 Valuation of a Bond . . . . . . . . . . . . . . . 4.2.1 Valuation of a Bond at Mark-To-Market 4.2.2 Valuation of a Bond at Funding . . . . 4.3 Convergence of the two Concepts . . . . . . . 5 6 7 Credit Valuation Adjustments Modeling and Implementation Conclusion

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References

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as we will illustrate. the multicurve model using determinstic default intensities in Section 2.2 Related Works The backward algorithm to valuate under different curves for borrowing and lending was already given in the textbook [4].com/ﬁnmath/discounting .9. In Section 3 we will then construct a different valuation which includes the funding costs of net cash requirements. counterparty risk and/or collateralization”. Accounting for operational cost we value it from the “inside”.christianfries.1) were also taken from this book. The answer depends on who you are and how we value.g.g.e. if we include the funding cost. The usual setup of other papers discussing “multiple” curves is to consider a two or three curve valuation framework: one (forward) curve for the indices (forward rates and swap rates). Those convexity adjustment are reﬂected by our (numerical) valuation algorithm once corresponding c 2010 Christian Fries 4 Version 0.. it is natural to ask “What is the discounting curve of a swap in the presence of funding costs.1 Two Different Valuations In Section 2 we will ﬁrst take a simpliﬁed view in valuing claims and cash ﬂows: We view the market price of a zero coupon bond as the value of a claim and value all claims according to such zero coupon bond prices.e. The two parties come to different values because of a very simple fact: We cannot short sell our own bond (sell protection on our self). a third party can do.” 1. However. and since we are not liquidating the portfolio we have to factor them in. This approach does not value funding cost.Discounting Revisited Christian Fries 1 Introduction Looking at the valuation of a swap when funding costs and counterparty risk are neglected (i. The difference of the two valuations is their point of view. i. [1. However. funding cost and netting agreements may imply that there is no such thing as a product independent discounting curve.4. These funding costs occur over the life time of the product. 1. However. Factoring in funding costs the answer to that question is “There is no such thing as a unique discounting curve (for swaps). when there is a unique risk free discounting curve). They are of course not present if the portfolio is liquidated. This alternative valuation will also give an answer to an otherwise puzzling problem: In the mark-tomarket valuation it appears that the value of the portfolio increases if its credit rating decreases (because liabilities are written down). e. Liquidating a portfolio we value it from “outside” as a third party.. Piterbarg [8] discusses the effects of the correlation term induced by a mismatch of the index and the discounting curve. We could call it the third party (mark-to-market) liquidation view which is to ask what is the value of a portfolio of claims if we liquidate it today..12 (20100530) http://www. Some of our examples below (e. 9]. one (discounting) curve for collateralized deals and one (discounting) curve for funded deals. However.. convexity adjustments. then the effect is reversed since funding costs are increased. see. this is only one point of view.

market prices often do not reﬂect that situation. t). Our approach is more general in the sense that we consider the true net cash position. e. See also the short comment after equation (2).. In theory a defaultable bond for which one buys protection should equal a non defaultable bond as long as the protection itself cannot default. for a zero coupon. i. For the modeling of rates (e. They showed that.. t) = P B (T .g. they consider the liquidation or inception of the deal (i.. correlations of rates and spreads) are introduced into the underlying model. [5]. With the possible exception of the Section 6 on “Modeling” we did not explicitly model the impact of liquidity or default risk. However.com/ﬁnmath/discounting . Morini and Prampolini clarify the relation of the so called bond-cds-basis. the premium payed for a future liability can always function as funding.g.1 The formulas derivend in [8] are of great importnance since they can be used to provide efﬁcient approximations for a multi-curve model’s calibration products. the mark-to-market valuation including own credit can be re-interpreted as a funding beneﬁt. 1 Our presentation is essntially “model free”. For the valuation of CVAs using the modeling of default times / stopping times to value the contract under default see [2] and Section 8 in [6]. there argument relies on the fact that there is a premium payed which can be factored in as a funding beneﬁt. the difference between bond spread and cds spread. where a funding beneﬁt may or may not occure (in a stochastic way). In [7] Morini and Prampolini cosidered a zero coupon bond together with its funding and counterparty risk... which is attributed to liquidity aspects of the products. i.e. In contrast to the CVA approach modeling default times we considered market prices of zero coupon bonds only and the valuation would require a model of the zero coupon bond process (one way is to modeling default times.Discounting Revisited Christian Fries assumptions (e.e. they consider a mark-to-market valuation). The net cash position will give rise to a complex disocunting algorithm.12 (20100530) http://www. hence funding cost beyond the bond-cds basis do not occure.e. However. through basis swap spreads) see.g. In the latter a homogeneity assumption is made resulting in P A (T . Doing so. c 2010 Christian Fries 5 Version 0.9.christianfries. another is to model spreads and survival probabilities).

0) P A (T . By this we mean that A offers the ﬁnancial product which offers the payment of 1 in time T ..12 (20100530) http://www. Since we view ourself as a third party. If we view a cash ﬂow |C(T )| between A and B from the perspective of the entity A such that C(T ) > 0 means that the cash ﬂow is incoming (positive value for A) and C(T ) < 0 means that the cash ﬂow is outgoing.1 Discount Factors for Outgoing and Incoming Cash Flows Assume entity A can issue a bond with maturity T and notional 1. i. 2.Discounting Revisited Christian Fries 2 Discounting Cash Flows: The Third Party (Mark-to-Market) Liquidation View Let us ﬁrst take the point of view of being a third party and value claims between to other entities A and B.com/ﬁnmath/discounting . T ). We will call this cash ﬂow “incoming”. T ). which is given by considering a single ﬁnancial product: the zero coupon bond. t) is the discount factor of all incoming cash ﬂows from entity B. Let us formalize this set up: 2.e. the time T value of this isolated cash ﬂow is C(T )P B (T . c 2010 Christian Fries 6 Version 0. The time T value of this cash ﬂow is −C(T )P A (T . the time t < T value of this isolated cash ﬂow then is C(T )P A (T . however we want to stress that we view ourself as a third party independent of A and B trading in bonds.1.9. This corresponds to A holding a zero coupon bond from entity B having notional C(T ) and maturity T . We lay the foundation of discounting. T ) + max(C(T ). Let us denote the time t market price of this product by P A (T .christianfries. we have that in this framework the discount factor of a cash ﬂow is determined by the value of the zero coupon bonds of the originating entity. Discounting. hence the minus sign. Given that C(T ) is not stochastic. t) is the discount factor of all outgoing cash ﬂows of entity A. discount factors are given by the price at which a zero coupon bond can be sold or bought. then its time T value can be written as min(C(T ). t) denote the price at which the market is willing to buy or sell bonds issued by some other entity B. Assume that A receives a cash ﬂow C(T ) > 0 from entity B. t). t). Thus we have: P A (T . T ) (seen from A’s perspective).1 Valuation of a Fixed Coupon Bond The knowledge of the discount factors allows the valuation of a ﬁxed coupon bond. 0) P B (T . Likewise let P B (T . Thus we have: P B (T . Given that C(T ) is not stochastic. Consider some other contract featuring a cash ﬂow C(T ) > 0 from A to B at time T . however we want to stress again that view ourself as a third party independent of A and B trading in bonds. the time t < T value of this isolated cash ﬂow then is C(T )P B (T . This is the value at which the market is willing to buy or sell this bond. t). We will call this cash ﬂow outgoing. Hence. because here all future cash ﬂows have the same origin. where we view the value from A’s perspective.

t. If C(T ) > 0 then |C(T )| ﬂows from B to A. t). T ) which would not be present if counterparty risk (and funding) would have been neglected. For example. t) contains the time-value of a cash ﬂow from A (e. then we effectively have a single contract with a single cash ﬂow of C(T ) := −C A (T ) + C B (T ). T ). T ) and + C B (T ) P B (T . seen from A’s perspective. and due to A’s credit risk we may have P A (T . ω) > 1 will be meaningful for some “virtual” entity AC . However.2.com/ﬁnmath/discounting . T.9. 1}. T ) + max(C(T ). t) = P B (T . 0) P A (T .g. As a consequence. but in general this property does not hold.christianfries. then the time t value of these cash ﬂows is −C A (T ) P A (T . In Section 2. If C A (T ) and C B (T ) are deterministic. Let C B (T ) > 0 denote the cash ﬂow originating from B to A.3 Netting Let us now consider that entity A and B have two contracts with each other: one resulting in a cash ﬂow from A to B. Individually the time T value of the two contracts is −C A (T ) P A (T . 0) P B (T . is min(C(T ). The origin of this cash ﬂow is now determined by its sign. ω) ∈ {0.2 Counterparty Risk The price P A (T . Let C A (T ) > 0 denote the cash ﬂow originating from A to B. then we have that P A (T . if we have a netting agreement.12 (20100530) http://www.6 we will see a case where P AC (T . Usually we expect 0 ≤ P A (T . t) =: P (T . ω) < 1 for some path ω. t) and + C B (T ) P B (T . namely for over-collateralized cash ﬂows from A. T.Discounting Revisited Christian Fries 2.. T. through a risk free interest rate) and the counterparty risk of A. t) then there is no difference between the value of a netted cash ﬂow and the sum the individual values. T ) ≤ 1.e. we will often use the symbol P A (T .1 Example If we do not consider “recoveries” then P A (T . c 2010 Christian Fries 7 Version 0. The time T value of the netted cash ﬂow C(T ). 2. i.. the two counter parties A and B agree that only the net cash ﬂow is exchanged. The other resulting in a cash ﬂow from B to A. Let us assume further that both cash ﬂow will occur at the same future time T . if entity A defaults in time τ (ω). T ). where the signs stem from considering the value from A’s perspective. Note that if P A (T . From B’s perspective we would have the opposite signs. If C(T ) < 0 then |C(T )| ﬂows from A to B. 2. respectively. ω) = 0 for t > τ (ω).

t) = N (t) EQ = N (t) EQ N P A (T . different discounting curves. Let N denote a numeraire and QN a corresponding martingale measure. i. T ) FT N (T ) 1 GT N (T ) T N P A (t. e.4.e. The analytic valuation (which actually stems from a static hedge) as C(T )P A (T . t) P A (t.12 (20100530) http://www. then we have to value their time t value using a valuation model.9. T ) |Ft N (T ) Note that the factor P A (T .. where the value is given as EQ N C(T ) P A (T .1 Example: A simple approach to construct a multi-curve model A simple approach to include counterparty risk.christianfries. such that. where Gt is the ﬁltration associated with our given the counterparty risk-free model.com/ﬁnmath/discounting . In theories where counterparty risk (and funding) is neglected. T ) which identiﬁes its counterparty (source).4 Valuation of Stochastic Cash Flows If cash ﬂows C(T ) are stochastic. T ) determines the effect of the origin of the cash ﬂow. the numeraire relative conditional expectation of the cashﬂow. t) N = EQ N (t) P A (T . outgoing from A is evaluated in the usual way. i. is given by the contitional c 2010 Christian Fries 8 Version 0. t) exp − t λA (τ ) dτ . EQ N (T ) 2. t) no longer holds. into a standard single curve interest rate model is by assuming a deterministic default intensity. here A. let Ft denote the ﬁltration including counterparty risk and assume that Ft = Gt × Ht . risk neutral valuation using some numeraire N and a corresponding martingale measure QN .Discounting Revisited Christian Fries 2.e. the cash ﬂow C(T ) is valued as C(T ) N |Ft . P A (T . T ) |Ft . we assume that default free payoffs are valued as P (T . To formalize this.g. So in other words. here A.. every time T cashﬂow has to carry a marker P A (T .. t) exp − t T λA (τ ) dτ = P (T . N (T ) Then a possibly stochastic cash ﬂow C(T ). In other words. The time t valuation of this cashﬂow. t) = N (t) EQ N 1 FT N (T ) = N (t) EQ N 1 GT N (T ) and we implicitly deﬁne the counterparty risk as P A (T .

t) N (t) P (T . In that case we also have N (t)EQ N P C (T . i. then P C has no credit risk. t). A pays 1 only if C survived. is not modelled at all. t) := N (t)EQ N (T ) | Ft . 2. with respect to the ﬁltration G of the single curve model) times the survival probablity times a new marker P A (t. Note that the default event.com/ﬁnmath/discounting .. They are all subsummed in the market implied default intensity λ. The assumption that the default intensity λ is deterministic is sufﬁcient to value the default indicator function. t) c 2010 Christian Fries 9 Version 0. t) P A (T . i. T ) | Ft N (T ) N = P C (T .9. t) P A (T . 2. In this case we have N (t)EQ N P C (T .5. Also. t) 1 where P (T .5 Credit Linking Let us consider a bond P C (T . t) 1 . This contract can been seen as a credit linked deal. The time T value of this cash ﬂow is P C (T . T.. t). then C defaults if and only if A defaults and there are no recoveries. T ) and P C (T . t). P (T . t) P A (T . the process P A (T ) is a QN -martingale (with respect to the full ﬁlration F.. ω) ∈ {0. t) issued by entity C. T )P A (T . T ) | Ft = P C (T .1 Examples If P C (T . t) 1 1 = P C (T . However. T ) | Ft N (T ) = P A (T . If the two random variables P A (T . Obviously. T ) | Ft N (T ) N = N (t) EQ P C (T .e. Let us consider a contract where A pays P C (T . See also Chapter 28 in [4]. the ﬁltration H. ω) = 1 for all ω ∈ Ω. T ). T ) in t = T . T )P A (T . If P C (T . Note that such a model does not explicitly distinguish liquiditiy effects and default risk effects. 1} for all ω ∈ Ω. T )P A (T . choose N = P (T ) such that N (T ) = 1) and get N N (t)EQ P C (T . T. T )P A (T .e.. T. T ) are independent we have N (t)EQ N P C (T .e. otherwise it will pay C’s recovery. ω) = P A (T .christianfries. T ) | Ft EQ N P A (T . T ) | Ft N (T ) = P A (T . To prove the latter we switch to terminal measure (i.e.Discounting Revisited Christian Fries expectation of the corresponding counterparty risk-free cashﬂow (i.12 (20100530) http://www. this cash ﬂow still is a cash ﬂow originating (granted) by A. T )P A (T .

the second contract evaluates to K.9. If we value both contracts separately. where we assumed that the net cash ﬂow is non-positive. T ) accounts for the fact that the collateral may itself default over the time. 10 ! c 2010 Christian Fries Version 0. assume that counterparty A holds a contract where an entity C will pay K in time T . T ) + K P C (T . T ) in t = T . T ) − P C (T . so we do not consider over-collateralization. Thus. which is the case if K < M and P C (T . however. The time T value thus is KP C (T . For simplicity let us consider the collateralization of a single future cash ﬂow. Hence. T ) − P C (T . We have KP C (T . we can re-interpret a collateralized contract as a contract with a different discount curve. As we will illustrate. t). T ) . T ) − P C (T . there is a cash ﬂow −M P A (T . The random variable P C (T . Thus. T ). Let us assume that counterparty A pays M in time T = 1. Next. T )P A (T . this is only a re-interpretation. Collateralization is an additional contract with an additional netting agreement (and a credit link). T ) = − M P A (T . the time t value of the non-collateralized cash ﬂow is −M P A (T . see “credit linked” above. T ) = KP C (T . seen from the perspective of A. This can be seen as letting the second contract default if the ﬁrst contract defaults. T ) . It is possible to view this change of the value of the portfolio as a change of the value of the outgoing cash ﬂow.12 (20100530) http://www. T ) − M P A (T . Hence. then the ﬁrst contract evaluates to −N . T ) ≤ 1. T ) − M P A (T . Let us determine the implied zero coupon bond process P AC such that −M P AC (T . T )P A (T . T )P A (T . seen from the the perspective of A there is a cash ﬂow KP C (T . If we use the second contract to “collateralize” the ﬁrst contract we bundle the two contracts in the sense that the second contract is passed to the counterparty B as a pawn.Discounting Revisited Christian Fries 2. T ) Thus. the difference of the value of the collateralized package and the sum of the individual deals (M − K) is K P C (T . T ) +K P C (T . T ) in t = T . T ) − M P A (T .christianfries. t). the time t value of this cash ﬂow is KP C (T .6 Collateralization Collateralization is not some “special case” which has to be considered in the above valuation framework.com/ﬁnmath/discounting .

T )P A (T .12 (20100530) http://www. This can be interpreted as: if the quality of the collateral is “less or equal” to the quality of the original counterpart. T ) − P C (T .Discounting Revisited Christian Fries It is P AC (T . T ). Given that P C (T . we can check some limit cases: • For P C (T .christianfries.9. T ) we ﬁnd that collateralization has a positive value for the entity receiving the collateral. for example. then the collateralized discount factor agrees with the discount factor of the collateral. T )P A (T . T ). T )) of the collateral. T ) |Ft N (T ) = exp(−r(T − t)) exp(−λA (T − t)) = exp(−r(T − t)) exp(−λC (T − t)) P C (T . T ) := P A (T . It should be noted that a corresponding zero coupon bond does not exist (though it may be synthesized) and that this discount factor is simply a computational tool. T ) = K αP C (T .e. T ) |Ft N (T ) P C (T . 2. T ) = P A (T . M (1) We refer to P AC as the discount factor for collateralized deals. then collateralization constitutes a mixing of the two discount factors at the ratio of the collateralized amount. T ) < 1 ⇒ P C (T . where α = M . i. T ) = P A (T . i. T ) = P A (T . T ). T ) + (1 − α)P A (T . the entity receiving collateral can save funding costs. T ) . note that the discount factor depends on the value (K) and quality (P C (T . 2. T ) = P C (T .com/ﬁnmath/discounting . T ) = P C (T .. if the collateral does not compromise the quality of the bond as a credit linked bond and the collateral matches the future cash ﬂow. • For P C (T . T ) − K P C (T .1 Interpretation From the above. T ) P A (T . T ) we ﬁnd that P AC (T .2 Example Let us consider entities A and C where N (t) EQ N N (t) EQ and N (t) EQ N N P A (T . T )P A (T . then collateralization has no effect. T ) and K = M we ﬁnd that P AC (T . T ) = P A (T . Hence. The reason can be interpreted in a funding sense: The interest payed on the collateral is less than the interest payed on an issued bond.e.6. if P A (T . 11 c 2010 Christian Fries Version 0. T ). In addition.6. • For P C (T . T ) |Ft N (T ) = exp(−r(T − t)) exp(−λC (T − t)) exp(−λA (T − t)). Note that this equations holds. T )P A (T . T ) and 0 ≤ K ≤ M we ﬁnd that P AC (T . if the collateral does not compromise the quality of the bond as a credit linked bond.. T )P A (T .

e. since we would need to consider the discount factor of the counterpart receiving the collateral (the the over-collateralized part is at risk now).com/ﬁnmath/discounting . However. c 2010 Christian Fries 12 Version 0. We excluded this case in the derivation and in fact the formula above does not hold in general for an over-collateralized deal. i. Note that for K > M this discount factor could have P AC (T . the third equation constitutes and assumption.3 Full Bilateral Collateralization Full bilateral collateralization with collateral having the same discount factor.Discounting Revisited Christian Fries The ﬁrst two equations could be viewed as a deﬁnition of some base interest rate level r and the counterparty dependent default intensities λ..christianfries. T ) > 1.6. a similar formula can be derived. 2. P AC (T ) = P BD (T ).12 (20100530) http://www. t) = exp(−r(T − t)) exp(−λA (T − t))· · 1+ K exp(−λC (T − t)) exp(λA (T − t)) − 1 M . Nevertheless. given that the base level r is given. So to some extend these equations are deﬁnitions and do not constitute an assumption.9. This would correspond to the case where the original deal is over-collateralized. From this we get for the impact of collateralization that P AC (T . namely that the defaults of A and C are independent. will result in a single discounting curve (namely that of the collateral) regardless of the origin of the cash ﬂow.

However. the insurance does not cover the event. Not paying is not an option.1 Moving Cash Flow through Time Axiom 1 requires that we consider transactions such that all future cash ﬂow is converted into todays cash ﬂow. future outgoing cash ﬂows have to be ensured.com/ﬁnmath/discounting . replicated). but if the default occurs.12 (20100530) http://www. At this point one may argue that a future outgoing cash ﬂow is not a problem. Dynamic hedges will be considered in Section 3. which we also label as an “Axiom”: Axiom 2: We cannot short sell our own bond. This relates to the “going concern” as a fundamental principle in accounting. Valuation is done by valuing hedging cost. liquidation is not an option) and cash ﬂows have to be “hedged” (i. neutralized. A itself cannot offer such an instrument. To illustrate the concept we ﬁrst consider deterministic cash ﬂows only... Future net (!) cash ﬂow is undesirable. Changing the point of view. then we would be exposed to risk in that asset.Discounting Revisited Christian Fries 3 Discounting Cash Flows: The Hedging View We now take a different approach in valuing cash ﬂows and we change our point of view. Once the cash has to ﬂow we just sell an asset.e. A bank hedges its risk and so future cash ﬂow has to be hedged as well. It would offer an insurance on its own default. In order to stay in business.christianfries. where then a netting of cash occurres. In addition we take a conservative point of view: a liability in the future (which cannot be neutralized by trading in some other asset (netting)) has to be secured in order to ensure that we stay in business.. Let us explore the means of “moving” cash through time. i. The costs or proceeds of this trading deﬁne the value of future cash ﬂows. We now assume that we are entity A and as a consequence postulate that Axiom 1: (Going Concern) Entity A wants to stay in business (i. An entity must do this because all uncovered negative net cash ﬂow will mean default.3. It does not earn interest.e. This is not the business model of a bank. Instead we value future cash ﬂows by trading in assets such that future cash ﬂows are hedged (neutralized). Hence the product is worthless. The axiom means that we do not value cash ﬂows by relating them to market bond prices (the liquidation view). assuming that we are entity A has another consequence. 3. This is to some extend reasonable since cash itself is a bad thing. It needs to be invested.e. Axiom 2 then restricts the means how we can move cash ﬂows around. These allow for static hedges through the construction of appropriate forward bonds in Section 3. We will take a replication / hedging approach to value future cash.9. A future cash ﬂow has to be managed.2. c 2010 Christian Fries 13 Version 0. The rationale of this is clear: While a third party E actually can short sell a bond issued by A by selling protection on A.

3. 3. Hence we have to consider two different forward bonds.3 3.t) today (in bonds P ◦ (T . We will later relax this assumption and allow for (partial) funding beneﬁts by buying back bonds.e. This is the way by which positive cash can be moved from T to an earlier time t < T. for example because there are no such bonds. This is the way by which negative cash can be moved from T to an earlier time t < T. This is the way by which positive cash can be moved from t to a later time T > t (risk less. e.e. The 1 cash ﬂow received in T then is N P ◦ (T .2 3. To comply with Axiom 2 we simply assume that we can only enter in one of the following transactions. which we consider next.t) (payment).9. Issuing a bond 1 generating cash ﬂow +N (proceeds) the cash ﬂow in T then is −N P A (T . we) is confronted with a cash ﬂow −N in time T it needs to hedge 1 (guarantee) this cash ﬂow by depositing −N P ◦ (T .. we) is confronted with a cash ﬂow +N in time T it needs to hedge (net) 1 this cash ﬂow by issuing a bond with proceeds N P A (T . i. This is the way by which negative cash can be moved from t to a later time T > t. let us assume that buying back bonds is currently not an option. t).2 Construction of Forward Bonds The basic instrument to manage cash ﬂows will be the forward bond transaction.Discounting Revisited Christian Fries Let us assume that there is a risk free entity issuing risk free bonds P ◦ (T .1. t) bond. However.1. there is no such thing as negative cash. Note that due to Axiom 2 it is not admissible to short sell our own bond.4 Hedging Positive Future Cash Flow If entity A (i. c 2010 Christian Fries 14 Version 0.2 Moving Negative Cash to the Future If entity A (i. t)). Either we have to sell assets or issue a bond.12 (20100530) http://www.3 Hedging Negative Future Cash Flow If entity A (i.. suitable for hedging). Assume for now that selling assets is not an option. In fact..1 Moving Positive Cash to the Future If entity A (i.1.t) today (in bonds P ◦ (T .e. t) by which we may deposit cash. we) has cash N in time t it can invest it and buy bonds P ◦ (T ... we) has cash −N in time t it has to issue a bond in order to cover this cash.e. t) of some other entity B is not admissible since then the future cash ﬂow would be credit linked to B.christianfries.t) . 3. Note that investing in to a bond P B (T .1.e.. 2 3 Counterparty risk will be considered at a later stage.g. A remark is in order now: An alternative to net a future outgoing cash ﬂow is by buying back a corresponding −P A (T . t)).com/ﬁnmath/discounting . never sell it.

Let (T . Note that the issued bond is securitized only over the (T1 .Discounting Revisited Christian Fries 3. us) in T1 . where this protection fee is paid in T2 .0) .1 respectively. • We net the incoming cash ﬂow by issuing a bond in t = 0 paying back −M .2. T1 ].2. Let (T1 . P This transaction has zero costs if N = M P ◦ (T2 . t).0) . t). Assume further that we can sell protection on N received from B at CDSB (T1 . T2 ) := P A (T2 ) .0) 1 A P A (T1 . 0). Then we perform the following transactions • We neutralize (secure) the outgoing cash ﬂow by an incoming cash ﬂow N by investing −N P ◦ (T2 .1 Forward Bond 1: Hedging Future Incoming Cash with Outgoing Cash Assume we haven an incoming cash ﬂow M from some counterparty risk free entity to entity A in time T2 and an outgoing cash ﬂow cash ﬂow −N from entity A (i. replacing M and N in 3. We assume that we can buy protection on M received from B at −CDSB (T2 . resulting in M P ◦ (T1 . Then we perform the following transactions • We neutralize (secure) the outgoing cash ﬂow by an incoming cash ﬂow N by investing −N P ◦ (T1 .3 P ◦ (T2 ) . where we securitize the issued bond by the investment in N P (T2 . c 2010 Christian Fries 15 Version 0. 0).com/ﬁnmath/discounting . 0) in time t = 0. 0). resulting P◦ in M P A (T2 . Assume we have an incoming cash ﬂow M from entity B to entity A in time T2 .christianfries. t)) and N (1 − CDSB (T1 . 0) P A(T1 .. we) to some other entity in time T1 .2.0) period [0. P ◦ (T1 ) Forward Bond 1’: Hedging Future Credit Linked Incoming Cash with Credit Linked Outgoing Cash In the presents of counterparty risk. P A (T1 ) 3.0) ◦ P ◦ (T1 .2.e. t) in T2 . t)).. the construction of the forward bond (discounting of an incoming cash ﬂow) is a bit more complex.e. T2 ) := 3.2 Forward Bond 2: Hedging Future Outgoing Cash with Incoming Cash Assume we haven an outgoing cash ﬂow −M in T2 and an incoming cash ﬂow N from some counterparty risk free entity to entity A (i. where we securitize the issued bond by the investment in N P ◦ (T1 .9. P This transaction has zero costs if N = M P A (T2 . 0) in time 0. In other words we perform the following transactions • We buy protection on B resulting in a cash ﬂow −M CDSB (T2 . • We net the incoming cash ﬂow by issuing a bond in t = 0 paying back −M .0) .12 (20100530) http://www. where this protection fee is paid in T1 . Then we repeat the construction of the forward bond with the net protected amounts M (1 − CDSB (T2 .

t) T2 r(τ . t)P ◦ (T2 . t) The latter can be interpreted as as a market implied survival probability. t) + sA (τ . t). • We sell protection on B resulting in a cash ﬂow N CDSB (T1 .Discounting Revisited Christian Fries • We issue a bond to net the T2 net cash ﬂow M (1 − CDSB (T2 . T2 ) := P A (T2 ) 1 − CDSB (T2 .t) . t) in T1 . while this construction will give us a cash ﬂow in T1 which is (because of selling protection) under counterparty risk. t))P ◦ (T1 . • We collateralized the issued bond using the risk free bond over [0. t) = ◦ . t)dτ c 2010 Christian Fries 16 Version 0. t) However. 3.2. t)). t) 1 − CDSB (T2 . netting of such a cash ﬂow will require more care. t) =: exp − P ◦ (T1 . t) =: exp − P A (T1 . This gives P B (T2 .4 Price of Counterparty Risk Protection We denote the price of one unit of counterparty risk protection until T2 as contracted in t by CDSB (T2 . t)) in T1 .0) 1−CDS (T . 0) in t to generate a cash ﬂow of N (1 − CDSB (T1 . t) . where we assume that the protection fee ﬂows in T2 (and independently of the default event). t)dτ T1 T2 T1 T2 T1 r(τ . P A (T1 ) 1 − CDSB (T1 . t).t) This transaction has zero costs if N = M P A (T1 .0) 1 P (T2 . t) = P ◦ (T2 . T1 ] resulting P◦ in proceeds M (1 − CDSB (T2 . t)dτ λB (τ .0) 1−CDSB (T2 .0) in t. t) P A (T2 .12 (20100530) http://www.5 Example: Expressing the Forward Bond in Terms of Rates If we deﬁne P ◦ (T2 .4. t) 1 − CDSB (T2 . Let 1 A B P A|B (T1 . P (T2 . (T . t) =: exp − 1 − CDSB (T1 .2. 0) P A(T1 .christianfries.9. t) + CDSB (T2 . If we do not consider liquidity effects a fair (mark-to-marked) valuation will give P B (T2 . 3. • We invest N (1 − CDSB (T1 . there we apply this construction with t = T1 such that selling protection does not apply.com/ﬁnmath/discounting . t))P A (T2 . We will consider this in Section 3.

which we do not do according to axiom 1. where nearby cash ﬂows are “netted” as good a possible. The difference of the two corresponds to the “operating costs of managing un-netted cash ﬂows”.. t)dτ (funding) compared to discounting an incoming cash ﬂow. in Section 3. In addition incoming cash ﬂows carry the counterparty risk by the additional discounting (cost of protection) at T exp − T12 λB (τ .com/ﬁnmath/discounting . The only way to reduce cash cost is to net them with other cash ﬂows (e. t)dτ had been derived. however we fund ourself at a higher rate. We will do so next. γ A = sA − λA ).christianfries. t) + λB (τ . liquidating there are no operating cost (so we save them).12 (20100530) http://www. This correlation will come in once we assume a dynamic model for the corresponding rates and consider dynamic hedges (e. except that there T2 exp − T1 r(τ . 3.3 Valuation with Hedging Costs in Cash ﬂow Management (Funding) The cash ﬂow replication value is now given by the optimal combination of forward bonds to hedge (replicate) the future cash ﬂow. t)dτ (2) and we see that discounting an outgoing cash ﬂow backward in time by buying the T corresponding forward bonds generates additional costs of exp − T12 sA (τ . The expression (2) is similar to a corresponding term in [7]. Clearly. in a time-discrete model). which are just the funding costs. the colleation between A’s funding and B’s counterparty risk. where γ A is the bond-cds basis (i.g. T2 ) = exp − T2 T1 r(τ . e.6 Interpretation: Funding Cost as Hedging Costs in Cash Flow Management From the above. If we have cash lying around we can invest only at a risk free rate. 4 Netting will play an important role how funding and counterparty risk will enter. This is given by a backward algorithm..g. The difference stems from the fact that [7] always factors in own-credit. Note that for the net exposure we have to net all cashﬂows related to a single counterpart. t) + γ A (τ . t)dτ . of assets generating higher returns). discounting each cash ﬂow according to the appropriate forward bond and then netting the result with the next cash ﬂow. t) + sA (τ . c 2010 Christian Fries 17 Version 0.Discounting Revisited Christian Fries then we have P A|B (T1 . in the end we can arrived at a similar result since the effective funding required applies only on the net amount (after all netting has been performed).9. However.3. for the net funding we have to net all cashﬂows over all counterparts. 3.e.2. we see that moving cash ﬂows around generates costs and the cash ﬂow replication value of future cash ﬂows will be lower than the portfolio liquidation value of future cash ﬂow.. However these costs are real.g. t) + λB (τ .4 Not that these single time step static hedges do not consider any correlation.

. Ti ) N (Ti ) . Ti . t) or P A (T1 ..g. the risk free rate. t) =: exp − P ◦ (Ti .3. 3.com/ﬁnmath/discounting . for t = S the forward bond P (S.. e. T2 − T1 P ◦ (T2 . using our two assumptions (Axiom 1 and Axiom 2) we arrived at a very natural situation.Discounting Revisited Christian Fries Let us ﬁrst consider the valuation neglecting counter party risk. Ti ] (which is usually case if we employ a numerical scheme like the Euler c 2010 Christian Fries 18 Version 0. T2 .g. The interest earned by depositing money (risk free) over a period [T1 .. our funding rate. Ti−1 ) is replaced by N (Ti−1 ) EQ Note: It is P A (Ti−1 . Ti−1 ) = N (Ti−1 ) EQ i. t)dτ and model (!) the process on the right hand side such that sA (τ . t) is just a bond.e. The interest to be paid for borrowing money over a period [T1 . P A (Ti . or.christianfries. T2 ] is (as seen in t) 1 P A (T1 .4. 3. Example: Implementation using Euler simulation of Spreads and Intensities If we express the bonds in terms of the risk free bond P ◦ . all future cash ﬂows exposed to counter party risk have been insured by buying the corresponding protection ﬁrst (and reducing net the cash ﬂow accordingly). T2 ] is P ◦ (T1 . e. If we are discounting / hedging stochastic cash ﬂows C(T ) a dynamic hedge is required and C(Ti )P A (Ti−1 .e. sA (τ . t) is FTi−1 -measurable for t ∈ [Ti−1 . t) −1 . T2 − T1 P A (T2 .3. t) deﬁne a static hedge in the sense that their value is known in t. t) Ti Ti−1 N N C(Ti )P A (Ti . Ti−1 ) = P A (Ti .2 From Static to Dynamic Hedging The forward bonds. Ti ) N (Ti ) .1 Interest for Borrowing and Lending Obviously. t) i. t) 1 −1 . Hence we are in a setup where interest for borrowing and lending are different.9. put differently. T .12 (20100530) http://www. P ◦ (T1 . t) i.. P A (Ti .e. We will detail the inclusion of counterparty risk in Section 3. T2 . The valuation theory in setups when rates for lending and borrowing are different is well understood. see for example [3]. Ti .

Ti ) FTi−1 + N (Ti ) (3) . Xi is the collateral margin call occurring in time t = Ti . e.9. If valued using the collateral curve P C = P ◦ these marginal collateral cash ﬂows have mark-to-market value zero (by deﬁnition of the collateral). the collateral cash ﬂow will generate additional costs. Ti ] from the portfolios net cash position Vid (Ti ). This amount is then transferred to Ti−1 using the appropriate forward bond (discounting) for netting with the next margining cash ﬂow Xi−1 . Hence we have to borrow or lend the net amount d Vid (Ti ) = Xi + Vi+1 (Ti ) over the period (Ti−1 . as if the collateralized swap is our only product.g.3. C(Ti ) N (Ti ) Ti exp − Ti−1 sA (τ .3 now carries over to the valuation of a portfolio of products hold by entity A.e. 0) A P (Ti .. Let us assume that this swap constitutes the only product of entity A and that we value cash ﬂows by a hedging approach. Ti ) N (Ti ) N = N (Ti−1 ) EQ and likewise for P B . Ti ) N (Ti ) d min(Xi + Vi+1 (Ti ). In this the algorithm (3) will determine the discount factor to be used in the period [Ti−1 . Taking into account that for cash we have different interest for borrowing and lending. d Here Vi+1 (Ti ) is the net cash position required in Ti to ﬁnance (e. This is the valuation under the assumption that the Xi is the net cash ﬂow of entity A.4 Valuation within a Portfolio Context . regardless of a product having an outgoing or incoming cash ﬂow. dynamically using the two forward bonds from Section 3.Discounting Revisited Christian Fries scheme for the simulation of spreads s and default intensities λ).3. i. Ti ].Valuing Funding Beneﬁts The situation of Section 3. These are given by the following recursive deﬁnition: Vid (Ti−1 ) N = EQ N (Ti−1 ) d max(Xi + Vi+1 (Ti ).g.3. fund) the future cash ﬂows in t > Ti . the package represents a continuous ﬂow of cash (margining).com/ﬁnmath/discounting . 0) ◦ P (Ti . Let us assume the swap is collateralized by cash. The package consisting of the swap’s (collateralized) cash ﬂows and the collateral ﬂows has a mark-to-market value of zero (valued according to Section 2).christianfries. by deﬁnition of the collateral.2. then we ﬁnd that for any cash ﬂow C(Ti ) N (Ti−1 ) EQ N C(Ti )P A (Ti . t)dτ P A (Ti−1 .. 3.12 (20100530) http://www.3 Valuation of a Single Product including Cash Flow Costs Let us consider the valuation of a collateralized swap being the only product held by entity A. Let us discuss a product having a cash ﬂow C(Ti ) in Ti being part of entity A’s portfolio resulting in a net (cash) position Vid (Ti ). However. Ti−1 ) 3.. c 2010 Christian Fries 19 Version 0.

Hence it is discounted with P A (resulting in a smaller value at t < Ti . Note that for t > Ti this cash ﬂow can provide a funding beneﬁt for a future negative cash ﬂow which would be considered in the case of a negative net position.4). Positive Net Position Given that our net position Vid (Ti ) is positive in Ti . compared to a discounting with P ◦ ). Factoring in the funding beneﬁt it is discounted with P A (resulting in a larger value at t < Ti . it can be included using the forward bond which includes the cost of protection of a corresponding cash ﬂow.4. then we can attribute for the required c 2010 Christian Fries 20 Version 0.9. Outgoing Cash Flow. 3. Negative Net Position Given that our net position Vid (Ti ) is negative in Ti .e. an incoming (positive) cash ﬂow C(Ti ) reduces the funding cost for the net position.4 Valuation with Counterparty Risk and Funding Cost So far Section 3 did not consider counterparty risk in incoming cash ﬂow.12 (20100530) http://www.1 Static Hedge of Counterparty Risk in the Absence of Netting Assume that all incoming cash ﬂows from entity B are subject to counterparty risk (default). This would be the case if we consider a portfolio of (zero) bonds only and there is no netting agreement. Of course.christianfries. Hence it represents a funding beneﬁt and is discounted with P ◦ (resulting in a larger value at t < Ti . compared to a discounting with P A ). that all cash ﬂows Xi. see 3.. Outgoing Cash Flow. but all outgoing cash ﬂow to entity B have to be served.3. T2 ) to net a T2 incoming cash ﬂow for which we have protection over [T1 . 3. Hence it is discounted with P ◦ (resulting in a smaller value at t < Ti . Negative Net Position Given that our net position Vid (Ti ) is negative in Ti .com/ﬁnmath/discounting . FT0 -measurable. Positive Net Position Given that our net position Vid (Ti ) is positive in Ti . compared to a discounting with P A ). It is not admissible to use the forward bond P A|B (T1 . i. Since there is no netting agreement we need to buy protection on each individual cash ﬂow obtained from B. Hence it does not require funding for t < Ti as long as our net cash position is positive. compared to a discounting with P ◦ ). Incoming Cash Flow. Bj If we assume. T2 ] with a T1 outgoing (to B) cash ﬂow and then buy protection only on the net amount. for simplicity.k received in Ti from some entity Bj are known in T0 . an outgoing (negative) cash ﬂow C(Ti ) can be served from the positive (net) cash position. an outgoing (negative) cash ﬂow C(Ti ) has to be funded on its own (as long as our net position remains negative). an incoming (positive) cash ﬂow C(Ti ) can be factored in at earlier time only by issuing a bond.Discounting Revisited Christian Fries Incoming Cash Flow.

So obviously we are attributing full protection costs for all incoming cash ﬂows and consider serving all outgoing cash ﬂow a must. we have a static hedge against counterparty risk) and our valuation algorithm becomes Vid (Ti−1 ) N = EQ N (Ti−1 ) d max(Xi + Vi+1 (Ti ).12 (20100530) http://www. One approach to account for the mismatch B is to buy protection over [Ti−1 . Although this is only a special case we already see that counterparty risk cannot be separated from funding since (4) makes clear that we have to attribute funding cost for the protection fees. the exposure).e. 0) A P (Ti .9.. This value is usually a part of the contract / netting agreement. Ti ) N (Ti ) d min(Xi + Vi+1 (Ti ). c 2010 Christian Fries 21 Version 0. the outstanding claim) is determined using the risk free curve for discounting. The netting agreement between two counterparties may (and will) be different from our funding adjusted netting. Usually it will be a mark-to-market valuation of V B at Ti . B Let us denote by VCLSOUT.. 5 We assumed that the protection fee is paid at the end of the protection period.4. 0) . Ti ] for the positive part of VCLSOUT. Presently we are netting Ti cash ﬂows with Ti−1 cash ﬂows in a speciﬁc way which attributes for our own funding costs. 0) + (1 − CDSBj (Ti . This is not exactly right. apply an additional discounting to each netted set of cash ﬂows between two counterparts.i (Ti ) and netted non-default value ViB (Ti ). 0) ◦ + P (Ti . where the time Ti net cash ﬂow Xi is given as Xi := Xi◦ + j k B j j min(Xi. For example. it is straight forward to include periodic protection fees. Ti ) and P B (Ti−1 .k is the k-th cash ﬂow (outgoing or incoming) between us and Bj at time Ti . T0 )) max(Xi.k .com/ﬁnmath/discounting . It appears as if we could then use the forward bond P A|B (Ti−1 .e. that in any cash ﬂow Xi.k .e. then additionally buy protection for the mismatch of the contracted default B value VCLSOUT. many contracts feature netting agreements which result in a “temporal netting” for cash ﬂows exchanged between two counterparts and only the net cash ﬂow carries the counterparty risk..i (Ti ) (i.e. Ti ) FTi−1 N (Ti ) (4) ..k we account for the full protection cost from T0 to Ti .2 Dynamic Hedge of Counterparty Risk in the Presence of Netting However.christianfries.Discounting Revisited Christian Fries protection fee in T0 (i. Bj Note again. B B j where Bj denote different counterparties and Xi. i.i (Ti ) the time Ti cash being exchanged / being at risk at Ti if counterparty B defaults according to all netting agreements (the deals close out). Ti ) on our future Ti net cash ﬂow and then net this one with all Ti−1 cash ﬂows.5 3. the contract may specify that upon default the close out of a product (i.

. Vi j (Ti−1 ) is the true portfolio impact (including side effects of funding) Bj if the ﬂows Xl.com/ﬁnmath/discounting . pj := CDSBj (Ti . l ≥ i. Ti ) N (Ti ) min(Vi (Ti ). Ti ) FTi−1 . valued in Ti . 0) − max(Vi (Ti ) − Vi j (Ti ). 0) ◦ P (Ti .Discounting Revisited B Christian Fries j As before let Xi. Ti ]. 0) ◦ P (Ti . Ti ) FTi−1 N (Ti ) B B . Ti ]. 0) B B B B B mismatch of liability in case of default is the net value including protection fees over the period [Ti−1 . Then Vi j (Ti ) := Ri j (Ti ) − pj max(Ri j (Ti ). 0) A P (Ti . 0) protection on netted value including our funding j + pj min(VCLSOUT. 0) A P (Ti . Let Vi (Ti ) := j Vi j (Ti ). 0) − min(Ri j (Ti ). + N (Ti ) (5) In our valuation the time Ti−1 value being exposed to entities Bj counterparty risk is given by Vi j (Ti−1 ) N := EQ N (Ti−1 ) + B B max(Vi (Ti ). Let Ri j (Ti ) := k B j j Xi.christianfries.k .9.e. i. where pj is the price of buying or selling one unit of protection against Bj over the period [Ti−1 . In other words. B The general valuation algorithm including funding and counterparty risk is then given as Vi (Ti−1 ) N = EQ N (Ti−1 ) max(Vi (Ti ).i (Ti ) and c 2010 Christian Fries 22 Version 0.12 (20100530) http://www. B In the case where the mismatch of contracted default value VCLSOUT. are removed from the portfolio.i (Ti ).k denote the k-th cash ﬂow (outgoing or incoming) exchanged between us and entity Bj at time Ti . including our future funding costs. 0) − min(Vi (Ti ) − Vi j (Ti ).k + Vi+1 (Ti ) B B denote the value contracted with Bj . Ti−1 ). Ti ) N (Ti ) min(Vi (Ti ).

but also to the loss of a potential funding beneﬁt. 0). Note that B • We not only account for the default risk with respect to our exposure (VCLSOUT. B B k . 0 = k j j Xi. In case of default these cashﬂows are lost. 3. • Buying protection against default has to be funded itself and we account for that. 0 = Ri j (Ti ) − pj max Ri j (Ti ). the presents of funding cost changes the picture signiﬁcantly: • The discount curve determining the collateral may be different from the curve discount curve attributing for the funding cost. the impact of default on funding. that the presents of funding cost may introduce counterparty risk into a collateralize (secured) deal.12 (20100530) http://www. The algorithms (5) values the so called wrong-way-risk.4.9.4..e.i (Ti )). The surprising result is. 0 . the collateral will not match the expected value of the future cashﬂows inclunding funding costs.k + Vi+1 (Ti ) − pj max B B B B B B B B B j j Xi. The mark-to-market value of a time Ti cash ﬂow is c 2010 Christian Fries 23 Version 0.3 Interpretation From algorithm (5) it is obvious that the valuation of funding (given by the discounting using either P ◦ or P A ) and the valuation of counterparty risk (given by buying/selling protection at p) cannot be separated.com/ﬁnmath/discounting .Discounting Revisited B Christian Fries netted non-default value Ri j (Ti ) is zero we arrive at Vi j (Ti ) := min Ri j (Ti ). i. As a consequence.in this case we get an additional discount factor on the positive part (exposure) of the netted value.e. the collateralized deal has to be valued within (5) to account for these effects. Hence. 0 = Ri j (Ti ) + pj max Ri j (Ti ). 4 The Relation of the Different Valuations Let us summarize the relation of the two different discounting in the presents of counterparty risk.k + Vi+1 (Ti ).4 The Collateralized Swap with Funding Costs Let us consider the collaterlaized swap again.christianfries.. the correlation between B counterparty default and couterparty exposure via the term pj max(Ri j (Ti ). i. 0 + (1 − pj ) max Ri j (Ti ). While the mark-to-market value of a collateralized (secured) cash ﬂow can be calculate off the curve implied by the collateral. • Collateral may require funding or may represent a funding beneﬁt. attributing for the protection costs. 3.

Using P B (Ti . c 2010 Christian Fries 24 Version 0. 6 This is. They also coincide if an outgoing cash ﬂow appears only in the situation of positive net cash in Ti (funding beneﬁt) and an incoming cash ﬂow appears only in the situation of negative net cash Ti (funding beneﬁt). Ti ) we can formally write cash ﬂow outgoing (C(Ti ) < 0) incoming (C(Ti ) > 0) discount factor over [Ti−1 . This will constitute the value of the product for the institution. Ti ).. • the product can be evaluated within its context in a portfolio of products owned by an institution. This is clear for the ﬁrst value. where the portfolio is valued with the algorithm (3).1 One Product .christianfries. Ti ) P B (Ti−1 .Two Values Given the valuation framework discussed above a product has at least two values: • the product can be evaluated “mark-to-marked” as a single product. the situation in [7]. However. For the second value. This value can be seen as a “fair” market price. This is the products marginal portfolio value. Ti )P ◦ (Ti−1 . Ti ) i i i−1 . Here the product is valued according to Section 2. This is the product’s idiosyncratic value. because netting is neglected all together.e. Ti ) In this situation a liability of A is written down.6 4. Put differently: The liquidation valuation neglects funding by assuming funding beneﬁts in all possible situations. assuming zero bond-cds basis spread.. The net cash position has to be determined with the backward algorithm (3) where each cash ﬂow Xi is adjusted according to his (netted) counterparty risk.com/ﬁnmath/discounting . removing the product from the portfolio can change the sign of netted cash ﬂow. Ti ] P A (Ti−1 . we do not have funding cost.9. Here the value of the product is given by the change of the portfolio value when the product is added to the portfolio. T )P A (T P P B (Ti−1 . hence change the choice of the chosen discount factors. Ti ) = P ◦ (Ti−1 .12 (20100530) http://www.e. Ti ) The two valuation concepts coincide when P A (Ti−1 . Ti ) B (T .Discounting Revisited Christian Fries cash ﬂow outgoing (C(Ti ) < 0) incoming (C(Ti ) > 0) discount factor over [Ti−1 . The hedging (replication) value of a time Ti cash ﬂow depends however on our net cash position. because in case of liquidation of A its counterparts accepts to receive less than the risk free discounted cash ﬂow today. Ti ) i−1 . Ti ) = P B (Ti−1 . because the net cash position decides if funding cost apply or a funding beneﬁt can be accounted for. i. including possible netting agreements and operating costs (funding). Ti ] positive net cash in T negative net cash in Ti A (T P P ◦ (Ti−1 . both valuations share the property that the sum of the values of the products belonging to the portfolio does not necessarily match the portfolio’s value. i.

note that the discount factor only depends on the net cash position. Let Π[V1 . T ) = P ◦ (T .2. Of course.12 (20100530) http://www. . T )). 4.3 Convergence of the two Concepts Not that if A runs a perfect business. lets us go back to the zero coupon bond from which we started and value it. If the net cash position in T is negative. T ). VN ](0) denote the hedging value of the portfolio of those products. For P B we get P B (T . This stems from assuming that the proceeds of the issued bond are invested risk fee. 0) (this is a liability). it would be unreasonable to issue a risky bond and invest its proceeds risk free.Discounting Revisited Christian Fries 4. This indicated that we should instead buy back the bond (or not issue it at all). 0). 0) if the time T net position is negative. T )P A (T . If the portfolio’s cash c 2010 Christian Fries 25 Version 0. VN . . there is even a more closer link between the two valuations.com/ﬁnmath/discounting .2 Valuation of a Bond at Funding Factoring in funding costs it appears as if issuing a bond would generate an instantaneous loss. Let us consider that entity A holds a large portfolio of products V1 . 0). VN (0) denote the mark-to-market (liquidation) value of those products. it would be indeed unreasonable to increase liabilities at this maturity and issue another bond. it’s value will be P A (T . we ﬁnd that both discounting methods agree and symmetry is restored. In that case. Let V1 (0). . . . However. 0) which means we should sell B’s bond if its return is below our funding (we should not hold risk free bonds if it is not necessary).christianfries. This will indeed represent loss compared to the mark-to-market value. However.9. T ) N (0)EQ | F0 N (T ) Assuming that A’s funding and B’s counterparty risk are independent from P ◦ (T ) we arrive at P A (T . 0) P B (T . . it is needed for funding). 4.1 Valuation of a Bond at Mark-To-Market Using the mark-to-market approach we will indeed recover the bonds market value −P A (T . . . 0) ◦ P (T . and if there are no risk in its other operations. 4. Likewise for P B (T ) we get +P B (T . . . . . then the market will likely value it as risk free and we will come close to P A (T . Considering the hedging cost approach we get for P A (T ) the value −P ◦ (T . If however our cash position is such that this bond represents a funding beneﬁt (in other words.2 Valuation of a Bond To test our frameworks. securing every future cash ﬂow by hedging it (using the risk free counterpart P ◦ (T .2. because the bond represents a negative future cash ﬂow which has to be discounted by P ◦ according to the above.

9. C(Ti ) < 0 then removing it the portfolio will be left with an un-netted incoming cash ﬂow C(Ti ). VN ](0) − Π[V1 . the valuation above is computationally very demanding. portfolio valuation is non-linear in the products and hence the sum of the mark-to-market valuation does not agree with the portfolio valuation with funding costs.e. which is according to our rules discounted with P A (Ti ). A linearization argument shows that it then hold (approximately) for products consisting of many small cash ﬂows. the entity A attributed for all non-netted cash ﬂows by considering issued bonds or invested money. . exchanged with a risk free entity. the valuation simpliﬁes signiﬁcantly if all counterparts share the same zero coupon bond curve P (T . then. Then we have Vjd (Tj ) = 0 for all j.12 (20100530) http://www. . While the use of a credit valuation adjustment may simplify the implementation of a valuation system it brings some disadvantages: c 2010 Christian Fries 26 Version 0. . . 5 Credit Valuation Adjustments The valuation deﬁned above includes counter party risk as well as funding cost.Discounting Revisited Christian Fries ﬂows are hedged in the sense that all future net cash ﬂows are zero. hence it is not straight forward to look at a single products behavior without valuing the whole portfolio. which is according to our rules discounted with P ◦ (Ti ). i. . if this cash ﬂow is outgoing. . Thus. the mark-to-market valuation which includes “own-credit” for liabilities corresponds to the marginal cost or proﬁt generated when removing the product from a large portfolio which includes ﬁnding costs. This is computationally demanding. . . If this cash ﬂow is incoming. Vk−1 . . VN ](0). Let Vk be a product consisting of a single cash ﬂow C(Ti ) in Ti . First. If the portfolio is fully hedged the all future cash ﬂows are netted. i. However.e. especially if Monte-Carlo simulations is used. t) and/or the curve for lending an borrowing agree. Hence. neglecting counterparty risk. As illustrated above. Likewise. there is no counter party risk adjustment. Vk+1 . we have (approximately) Vk (0) ≈ Π[V1 . . .com/ﬁnmath/discounting . valuing a whole portfolio using the above valuation. However. Second. A credit valuation adjustment is simply a splitting of the following form V (t) = V |P · =P ∗ (t) + (V (t) − V |P · =P ∗ (t)) CVA where V |P · =P ∗ (t) denotes the simpliﬁed valuation assuming a single discounting curve P ∗ (neglecting the origin or collateralization of cash ﬂows). . all products have to be valued together. C(Ti ) > 0 then removing it the portfolio will be left with an un-netted outgoing cash ﬂow −C(Ti ). even very simple products like a swap have to be evaluated in a backward algorithm using conditional expectations in order to determine the net exposure and their effective funding costs.christianfries. Hence the marginal value of this product corresponds to the mark-to-market valuation. We proof this result only for product consisting of a single cash ﬂow. In other words.

Depending on the cash ﬂow the term C(T )P A (T . T ) and the corresponding time t < T value was expressed using risk neutral valuation N (0)EQ N C(T )P A (T . T ) F0 . We assume that the discretization scheme of the model primitives models the counterparty risk over the interval [ti . ti )ds is deterministic. i c 2010 Christian Fries 27 Version 0.12 (20100530) http://www. ti )ds represents an additional “discounting” stemming from the issuers credit risk / funding costs. counterparty risk and collateralization effects by two modiﬁcations: • The model is augmented by a simulation of the (conditional) one step (forward) t survival probabilities (or funding spreads). The value of a stochastic time T cash ﬂow C(T ) originating from entity A was given as of time T as C(T )P A (T . In order to cope with this problem we propose the following setup: • Construction of proxy discounting curve P ∗ such that the CVA is approximately zero. in general. t). 7 t “ R ” t A very simple model is to assume that exp − t i+1 λA (s. is not correct. e. It can be interpreted as and (implied) survival probability (see Chapter 28 in [4]).7 Hence any counterparty-risk-free valuation model can be augmented with funding costs. exp − tii+1 λA (s. T ) may give rise to valuation changes stemming from the covariance of A C(T ) and P N(T . ti+1 ) Fti+1 N (ti ) C(ti+1 ) N = N (ti )EQ Fti exp − N (ti+1 ) N ti+1 ti (6) λ (s.T ) .Discounting Revisited Christian Fries • The valuation using the simpliﬁed single curve.g. in general. A The expression exp − tii+1 λA (s. N (T ) Our presentation was model independent so far. are wrong.com/ﬁnmath/discounting . (T ) For an implementation of the valuation algorithm consider a time discretization 0 =: t0 < t1 < · · · < tn .. • The valuation is performed using the backward algorithm (3).9. where in each time step the survival probabilities and/or funding adjusted discount factors are applied according to (6).christianfries. • Hedge parameters (sensitivities) calculated such valuation. 6 Modeling and Implementation So far we expressed all valuation in terms of products of cash ﬂows and zero coupon bond processes like P A (T . ti+1 ) as an Fti -measurable survival probability such that we have for all ti+1 cash ﬂows C(ti+1 ) that N (ti )EQ C(ti+1 )P A (ti+1 . ti )ds . • Transfer of sensitivity adjustments calculated from the CVA’s sensitivities. ti )ds .

This is also reasonable since funding cost (operating costs) have risen. After our discussion the situation now appears much clear: This increase in value is reasonable when considering the portfolios liquidation since lenders are willing to accept a lower return upon liquidation in exchange for the increased credit risk.9. The two notion of valuation can co-exist. c 2010 Christian Fries 28 Version 0.christianfries.12 (20100530) http://www. The other should be used for risk management and the governance (managing) of positions. They do not contradict.com/ﬁnmath/discounting . We sheded some light on the own credit risk paradox that the mark-to-market value of a portfolio increases if its owner’s credibility decreases.Discounting Revisited Christian Fries 7 Conclusion We considered the valuation of cash ﬂows including counterparty risk and funding. To see the effect of a single deal on the cash ﬂow management the bank could use a curve for borrowing and lending and every deal would have to be valuated according to the algorithm (3). One discounting should be used for mark-to-market valuation. If we value the portfolio under a hedging perspective (where hedging to some extend means funding) we see that the portfolio value decreases if its owner’s credibility decreases.

http://ssrn. [7] M ORINI . [3] E BMEYER . Theory. John Wiley & Sons. A NDREA . PAPATHEODOROU . DAMIANO . Implementation. A NDREA: Risky funding: a uniﬁed framework for counterparty and liquidity charges. Bielefeld. [6] M ORINI . http://ssrn.3331v3. D IRK: Essays on Incomplete Financial Markets. P RAMPOLINI . VASILEIOS: Bilateral counterparty risk valuation for interest-rate products: impact of volatilities and correlations.Discounting Revisited Christian Fries References [1] B IANCHETTI . One Price: Pricing & Hedging Interest Rate Derivatives Using Different Yield Curves for Discounting and Forwarding. M ASSIMO .christian-fries. FABIO: LIBOR Market Models with Stochastic Basis. University of Bielefeld. C HRISTOPHER: The price is wrong. Risk magazine.com/abstract=1334356. Risk magazine.12 (20100530) http://www. Modeling. [9] W HITTALL .com/ﬁnmath/discounting . [8] P ITERBARG .com/ abstract=1506046. http://ssrn. M ARCO:Two Curves. January 2009. http://www. [5] M ERCURIO . 2009.de/finmath/book.: Mathematical Finance. Doctoral Thesis. V LADIMIR: Funding beyond discounting: collateral agreements and derivatives pricing. March 2010. March 2010. c 2010 Christian Fries 29 Version 0. M ASSIMO: Solving the puzzle in the interest rate market.christianfries. 2007. PALLAVICINI . ISBN 0-470-04722-4. 2010. arXiv:0911. [2] B RIGO . 2010.com/abstract=1506046. [4] F RIES . February 2010. C HRISTIAN P.9.

CVA. Netting. Own Credit Risk. 0 ﬁgures.9.Discounting Revisited Christian Fries Notes Suggested Citation F RIES . I. http://www. Liquidity Risk 30 pages. Valuation under Funding. c 2010 Christian Fries 30 Version 0. Valuation.de/finmath/discounting Classiﬁcation Classiﬁcation: MSC-class: 65C05 (Primary). Collateral. Counterparty Risk. G13. DVA. Keywords: Discounting. Credit Risk. ACM-class: G. C HRISTIAN P. Bond.christian-fries.com/ﬁnmath/discounting . Wrong Way Risk. 60H35 (Secondary).3.com/abstract=1609587. Counterparty Risk and Collateralization. http://papers.8.christianfries. (2010). 0 tables.: Discounting Revisited. 68U20. JEL-class: C15.6.12 (20100530) http://www.ssrn. Swap.

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