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Springer Proceedings in Mathematics & Statistics

Kathrin Glau
Zorana Grbac
Matthias Scherer
Rudi Zagst Editors

Innovations
in Derivatives
Markets
Fixed Income Modeling, Valuation
Adjustments, Risk Management,
and Regulation
Springer Proceedings in Mathematics & Statistics

Volume 165
Springer Proceedings in Mathematics & Statistics

This book series features volumes composed of selected contributions from

workshops and conferences in all areas of current research in mathematics and
statistics, including operation research and optimization. In addition to an overall
evaluation of the interest, scientific quality, and timeliness of each proposal at the
hands of the publisher, individual contributions are all refereed to the high quality
standards of leading journals in the field. Thus, this series provides the research
community with well-edited, authoritative reports on developments in the most
exciting areas of mathematical and statistical research today.

More information about this series at http://www.springer.com/series/10533

Kathrin Glau Zorana Grbac
•

Matthias Scherer Rudi Zagst

•

Editors

Innovations in Derivatives
Markets
Fixed Income Modeling, Valuation
Adjustments, Risk Management,
and Regulation
Editors
Kathrin Glau Matthias Scherer
Lehrstuhl für Finanzmathematik Lehrstuhl für Finanzmathematik
Technische Universität München Technische Universität München
Garching-Hochbrück Garching-Hochbrück
Germany Germany

Zorana Grbac Rudi Zagst

LPMA Lehrstuhl für Finanzmathematik
Université Paris–Diderot (Paris 7) Technische Universität München
Paris Cedex 13 Garching-Hochbrück
France Germany

ISSN 2194-1009 ISSN 2194-1017 (electronic)

Springer Proceedings in Mathematics & Statistics
ISBN 978-3-319-33445-5 ISBN 978-3-319-33446-2 (eBook)
DOI 10.1007/978-3-319-33446-2

Library of Congress Control Number: 2016939102

© The Editor(s) (if applicable) and The Author(s) 2016. This book is published open access.
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Preface

The financial crisis of 2007–2009 swallowed billions of dollars and caused many
corporate defaults. Massive monetary intervention by the US and European central
bank stabilized the global financial system, but the long-term consequences of this
low interest rate/high government debt policy remain unclear. To avoid such crises
scenarios in the future, better regulation was called for by many politicians. The
market for portfolio credit derivatives has almost dried out in the aftermath of the
crisis and has only recently recovered. Banks are not considered default free any-
more, their CDS spreads can tell the story. This has major consequences for OTC
derivative transactions between banks and their clients, since the risk of a coun-
terparty credit default cannot be neglected anymore. Concerning interest rates, it has
become unclear if there are risk-free rates at all, and if so, how these should be
modeled. On top, we have observed negative interest rates for government bonds of
countries like Switzerland, Germany, and the US—a feature not captured by many
stochastic models.
The conference Innovations in Derivatives Markets—Fixed income modeling,
valuation adjustments, risk management, and regulation, March 30–April 1, 2015
at the Technical University of Munich shed some light on the tremendous changes
in the financial system. We gratefully acknowledge the support by the KPMG
Center of Excellence in Risk Management, which allowed us to bring together
leading experts from fixed income markets, credit modeling, banking, and financial
engineering. We thank the contributing authors to this volume for presenting the
state of the art in postcrisis financial modeling and computational tools. Their
contributions reflect the enormous efforts academia and the financial industry have
invested in adapting to a new reality.
The financial crisis made evident that changes in risk attitude are imperative. It is
therefore fortunate that postcrisis mathematical finance has immediately accepted to
go the path of critically reflecting its old paradigms, identifying new rules, and,
finally, implementing the necessary changes. This renewal process has led to a
paradigm shift characterized by a changed attitude toward—and a reappraisal of—
liquidity and counterparty risk. We are happy that we can invite the reader to gather

v
vi Preface

insight on these changes, to learn which assumptions to trust and which ones to
replace, as well as to enter into the discussion on how to overcome the current
difficulties of a practical implementation.
Among others, the plenary speakers Damiano Brigo, Stéphane Crépey, Ernst
Eberlein, John Hull, Wolfgang Runggaldier, Luis Seco, and Wim Schoutens are
represented with articles in this book. The process of identifying and incorporating
key features of financial assets and underlying risks is still in progress, as the reader
can discover in the form of a vital panel discussion that complements the scientific
contributions of the book. The book is divided into three parts. First, the vast field
of counterparty credit risk is discussed. Second, FX markets and particularly
multi-curve interest-rate models are investigated. The third part contains innova-
tions in financial engineering with diverse topics from dependence modeling,
measuring basis spreads, to innovative fee structures for hedge funds.
We thank the KPMG Center of Excellence in Risk Management for the oppor-
tunity to publish this proceedings volume with online open access and acknowledge
the fruitful collaboration with Franz Lorenz, Matthias Mayer, and Daniel Sommer.
Moreover, we thank all speakers, visitors, the participants of the panel discussion—
Damiano Brigo, Christian Fries, John Hull, Daniel Sommer, and Ralf Werner—and
the local supporting team—Bettina Haas, Mirco Mahlstedt, Steffen Schenk, and
Thorsten Schulz—who helped to make this conference a success.

Garching-Hochbrück, Germany Kathrin Glau

Paris Cedex 13, France Zorana Grbac
Garching-Hochbrück, Germany Matthias Scherer
Garching-Hochbrück, Germany Rudi Zagst
Foreword

The conference “Innovations in Derivatives Markets—Fixed Income Modelling,

Valuation Adjustments, Risk Management, and Regulation” was held on the
campus of Technical University of Munich in Garching-Hochbrück (Munich) from
March 30, until April 1, 2015. Thanks to the great efforts of the organizers, the
scientific committee, the keynote speakers, contributors, and all other participants,
the conference was a huge success, bringing together academics and practitioners to
learn about and to discuss state-of-the-art derivatives valuation and mathematical
finance. More than 200 participants (35 % of whom were academics, 60 % prac-
titioners, and 5 % students) had many fruitful discussions and exchanges during
three days of talks.
The conference “Innovations in Derivatives Markets” and this book are part of
an initiative that was founded in 2012 as a cooperation between the Chair of
Mathematical Finance at the Technical University of Munich and KPMG AG
Wirtschaftsprüfungsgesellschaft. This cooperation is based on three pillars: first
strengthening a scientifically challenging education of students that at the same time
addresses real-world topics, second supporting research with particular focus on
young researchers, and third, bringing together academic researchers with practi-
tioners from the financial industry in the areas of trading, treasury, financial engi-
neering, risk management, and risk controlling in order to develop trendsetting and
viable improvements in the effective management of financial risks.
The main focus of the conference was the topic of derivatives valuation which is
a subject of great importance for the financial industry, specifically the rise of new
valuation adjustments commonly referred to as “XVAs”. These XVAs have gained
significant attention ever since the financial crisis in 2008 when banks suffered
tremendous losses due to counterparty credit risk reflected in derivatives valuation
via the credit valuation adjustment, CVA. A debate on the incorporation of funding
costs in derivatives valuation starting in 2012 introduced a new letter to the XVA
alphabet, the so-called funding valuation adjustment, FVA, together with its
specific impact in banks’ profit and loss statements. With the conference, we
intended to discuss these topics in the light of market evolutions, regulatory change,

vii
viii Foreword

and state-of-the-art research in financial mathematics by bringing together

renowned scientists, practitioners, and ambitious young researchers.
Over the first two days of the conference, several keynote speeches and invited
talks addressed various aspects of derivatives valuation. Topics included the fun-
damental change of moving from one interest rate curve to a multiple curve
environment, taking into account counterparty credit risk and funding into
derivatives valuation, new approaches to modeling negative interest rates, and also
presenting other advances in mathematical finance. The panel discussion on the first
day brought together the views of renowned representatives from academia and the
financial industry on the necessity, reasonableness and, to some extent, the future of
derivatives valuation and XVAs. The conference was rounded out by a day of
contributed talks, giving young researchers the opportunity to present and discuss
their results in front of a broad audience. All in all, the topics presented during the
conference covered a large spectrum, ranging from market developments and the
management of derivative valuation adjustments to theoretical advances in financial
mathematics.
We would like to thank everyone who contributed to make this event a great
success. In particular, we express our gratitude to the scientific committee, namely
Kathrin Glau, Zorana Grbac, Matthias Scherer, and Rudi Zagst, the organizational
team, namely Kathrin Glau, Bettina Haas, Mirco Mahlstedt, Matthias Scherer,
Steffen Schenk, Thorsten Schulz, and Rudi Zagst, the keynote speakers, the mod-
erator and participants of the panel discussion, all speakers of invited and contributed
talks, and, last but not least, all participants that attended the conference.
We are convinced that this book will help you to gain insights about
state-of-the-art research in the area of mathematical finance and to broaden your
horizon on the use of mathematical concepts to the fields of derivatives valuation
and risk management.

Dr. Matthias Mayer

Dr. Daniel Sommer
Franz Lorenz
KPMG AG Wirtschaftsprüfungsgesellschaft
Contents

Part I Valuation Adjustments

Nonlinearity Valuation Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Damiano Brigo, Qing D. Liu, Andrea Pallavicini and David Sloth
Analysis of Nonlinear Valuation Equations Under Credit and
Funding Effects. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Damiano Brigo, Marco Francischello and Andrea Pallavicini
Nonlinear Monte Carlo Schemes for Counterparty Risk on
Credit Derivatives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Stéphane Crépey and Tuyet Mai Nguyen
Tight Semi-model-free Bounds on (Bilateral) CVA . . . . . . . . . . . . . . . . 83
Jördis Helmers, Jan-J. Rückmann and Ralf Werner
CVA with Wrong-Way Risk in the Presence of Early Exercise . . . . . . . 103
Roberto Baviera, Gaetano La Bua and Paolo Pellicioli
Simultaneous Hedging of Regulatory and Accounting CVA . . . . . . . . . 117
Christoph Berns
Capital Optimization Through an Innovative CVA Hedge . . . . . . . . . . 133
Michael Hünseler and Dirk Schubert
FVA and Electricity Bill Valuation Adjustment—Much
of a Difference? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
Damiano Brigo, Christian P. Fries, John Hull, Matthias Scherer,
Daniel Sommer and Ralf Werner

Part II Fixed Income Modeling

Multi-curve Modelling Using Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
John Hull and Alan White

ix
x Contents

Derivative Pricing for a Multi-curve Extension of the Gaussian,

Exponentially Quadratic Short Rate Model . . . . . . . . . . . . . . . . . . . . . 191
Zorana Grbac, Laura Meneghello and Wolfgang J. Runggaldier
Multi-curve Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
Christian P. Fries
Impact of Multiple-Curve Dynamics in Credit Valuation
Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
Giacomo Bormetti, Damiano Brigo, Marco Francischello
and Andrea Pallavicini
A Generalized Intensity-Based Framework for Single-Name Credit
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
Frank Gehmlich and Thorsten Schmidt
Option Pricing and Sensitivity Analysis in the Lévy Forward
Process Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
Ernst Eberlein, M’hamed Eddahbi and Sidi Mohamed Lalaoui Ben Cherif
Inside the EMs Risky Spreads and CDS-Sovereign Bonds Basis . . . . . . 315
Vilimir Yordanov

Part III Financial Engineering

Basket Option Pricing and Implied Correlation in a One-Factor
Lévy Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
Daniël Linders and Wim Schoutens
Pricing Shared-Loss Hedge Fund Fee Structures . . . . . . . . . . . . . . . . . 369
Ben Djerroud, David Saunders, Luis Seco and Mohammad Shakourifar
Negative Basis Measurement: Finding the Holy Scale . . . . . . . . . . . . . . 385
German Bernhart and Jan-Frederik Mai
The Impact of a New CoCo Issuance on the Price Performance
of Outstanding CoCos. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405
Jan De Spiegeleer, Stephan Höcht, Ine Marquet and Wim Schoutens
The Impact of Cointegration on Commodity Spread Options . . . . . . . . 421
Walter Farkas, Elise Gourier, Robert Huitema and Ciprian Necula
The Dynamic Correlation Model and Its Application to the
Heston Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
L. Teng, M. Ehrhardt and M. Günther
 Part I
Valuation Adjustments
Nonlinearity Valuation Adjustment
Nonlinear Valuation Under Collateralization,
Credit Risk, and Funding Costs

Damiano Brigo, Qing D. Liu, Andrea Pallavicini and David Sloth

Abstract We develop a consistent, arbitrage-free framework for valuing derivative

trades with collateral, counterparty credit risk, and funding costs. Credit, debit, liq-
uidity, and funding valuation adjustments (CVA, DVA, LVA, and FVA) are simply
introduced as modifications to the payout cash flows of the trade position. The frame-
work is flexible enough to accommodate actual trading complexities such as asym-
metric collateral and funding rates, replacement close-out, and re-hypothecation of
posted collateral—all aspects which are often neglected. The generalized valuation
equation takes the form of a forward–backward SDE or semi-linear PDE. Neverthe-
less, it may be recast as a set of iterative equations which can be efficiently solved
by our proposed least-squares Monte Carlo algorithm. We implement numerically
the case of an equity option and show how its valuation changes when including
the above effects. In the paper we also discuss the financial impact of the proposed
valuation framework and of nonlinearity more generally. This is fourfold: First, the
valuation equation is only based on observable market rates, leaving the value of a
derivatives transaction invariant to any theoretical risk-free rate. Secondly, the pres-
ence of funding costs makes the valuation problem a highly recursive and nonlinear
one. Thus, credit and funding risks are non-separable in general, and despite com-
mon practice in banks, CVA, DVA, and FVA cannot be treated as purely additive
adjustments without running the risk of double counting. To quantify the valua-
tion error that can be attributed to double counting, we introduce a “nonlinearity
valuation adjustment” (NVA) and show that its magnitude can be significant under
asymmetric funding rates and replacement close-out at default. Thirdly, as trading

D. Brigo (B) · Q.D. Liu · A. Pallavicini

Department of Mathematics, Imperial College London, London, UK
e-mail: damiano.brigo@imperial.ac.uk
Q.D. Liu
e-mail: daphne.q.liu@gmail.com
A. Pallavicini
Banca IMI, largo Mattioli 3, Milan 20121, Italy
e-mail: andrea.pallavicini@imperial.ac.uk
D. Sloth
Rate Options & Inflation Trading, Danske Bank, Copenhagen, Denmark
e-mail: dap@danskebank.com

© The Author(s) 2016 3

K. Glau et al. (eds.), Innovations in Derivatives Markets, Springer Proceedings
in Mathematics & Statistics 165, DOI 10.1007/978-3-319-33446-2_1
4 D. Brigo et al.

parties cannot observe each others’ liquidity policies nor their respective funding
costs, the bilateral nature of a derivative price breaks down. The value of a trade to a
counterparty will not be just the opposite of the value seen by the bank. Finally, val-
uation becomes aggregation-dependent and portfolio values cannot simply be added
up. This has operational consequences for banks, calling for a holistic, consistent
approach across trading desks and asset classes.

Keywords Nonlinear valuation · Nonlinear valuation adjustment NVA · Credit risk ·

Credit valuation adjustment CVA · Funding costs · Funding valuation adjustment
FVA · Consistent valuation · Collateral

1 Introduction

Recent years have seen an unprecedented interest among banks in understanding

the risks and associated costs of running a derivatives business. The financial crisis
in 2007–2008 made banks painfully aware that derivative transactions involve a
number of risks, e.g., credit or liquidity risks that they had previously overlooked
or simply ignored. The industry practice for dealing with these issues comes in the
form of a series of price adjustments to the classic, risk-neutral price definition of a
contingent claim, often coined under mysteriously sounding acronyms such as CVA,
DVA, or FVA.1 The credit valuation adjustment (CVA) corrects the price for the
expected costs to the dealer due to the possibility that the counterparty may default,
while the so-called debit valuation adjustment (DVA) is a correction for the expected
benefits to the dealer due to his own default risk. Dealers also make adjustments due
to the costs of funding the trade. This practice is known as a liquidity and funding
valuation adjustment (LVA, FVA). Recent headlines such as J.P. Morgan taking a hit of
$1.5 billion in its 2013 fourth-quarter earnings due to funding valuation adjustments
underscores the sheer importance of accounting for FVA.
In this paper we develop an arbitrage-free valuation approach of collateralized as
well as uncollateralized trades that consistently accounts for credit risk, collateral,
and funding costs. We derive a general valuation equation where CVA, DVA, collat-
eral, and funding costs are introduced simply as modifications of payout cash flows.
This approach can also be tailored to address trading through a central clearing house
(CCP) with initial and variation margins as investigated in Brigo and Pallavicini [6].
In addition, our valuation approach does not put any restrictions on the banks’ liq-
uidity policies and hedging strategies, while accommodating asymmetric collateral
and funding rates, collateral rehypothecation, and risk-free/replacement close-out
conventions. We present an invariance theorem showing that our valuation equa-

1 Recently, a new adjustment, the so-called KVA or capital valuation adjustment, has been proposed

to account for the capital cost of a derivatives transaction (see e.g. Green et al. [26]). Following the
financial crisis, banks are faced by more severe capital requirements and leverage constraints put
forth by the Basel Committee and local authorities. Despite being a key issue for the industry, we
will not consider costs of capital in this paper.
Nonlinearity Valuation Adjustment 5

tions do not depend on some unobservable risk-free rates; valuation is purely based
on observable market rates. The invariance theorem has appeared first implicitly in
Pallavicini et al. [33], and is studied in detail in Brigo et al. [15], a version of which
is in this same volume.
Several studies have analyzed the various valuation adjustments separately, but
few have tried to build a valuation approach that consistently takes collateralization,
counterparty credit risk, and funding costs into account. Under unilateral default risk,
i.e., when only one party is defaultable, Brigo and Masetti [4] consider valuation of
derivatives with CVA, while particular applications of their approach are given in
Brigo and Pallavicini [5], Brigo and Chourdakis [3], and Brigo et al. [8]; see Brigo et
al. [11] for a summary. Bilateral default risk appears in Bielecki and Rutkowski [1],
Brigo and Capponi [2], Brigo et al. [9] and Gregory [27] who price both the CVA and
DVA of a derivatives deal. The impact of collateralization on default risk has been
investigated in Cherubini [20] and more recently in Brigo et al. [7, 12]. Assuming no
default risk, Piterbarg [36] provides an initial analysis of collateralization and funding
risk in a stylized Black–Scholes economy. Morini and Prampolini [31], Fries [25]
and Castagna [19] consider basic implications of funding in presence of default
risk. However, the most comprehensive attempts to develop a consistent valuation
framework are those of Burgard and Kjaer [16, 17], Crépey [21–23], Crépey et al.
[24], Pallavicini et al. [33, 34], and Brigo et al. [13, 14].
We follow the works of Pallavicini et al. [34], Brigo et al. [13, 14], and Sloth [37]
and consider a general valuation framework that fully and consistently accounts for
collateralization, counterparty credit risk, and funding risk when pricing a derivatives
trade. We find that the precise patterns of funding-adjusted values depend on a number
of factors, including the asymmetry between borrowing and lending rates. Moreover,
the introduction of funding risk creates a highly recursive and nonlinear valuation
problem. The inherent nonlinearity manifests itself in the valuation equations by
taking the form of semi-linear PDEs or BSDEs.
Thus, valuation under funding risk poses a computationally challenging problem;
funding and credit costs do not split up in a purely additive way. A consequence of this
is that valuation becomes aggregation-dependent. Portfolio values do not simply add
up, making it difficult for banks to create CVA and FVA desks with separate and clear-
cut responsibilities. Nevertheless, banks often make such simplifying assumptions
when accounting for the various price adjustments. This can be done, however, only
at the expense of tolerating some degree of double counting in the different valuation
adjustments.
We introduce the concept of nonlinearity valuation adjustment (NVA) to quantify
the valuation error that one makes when treating CVA, DVA, and FVA as separate,
additive terms. In particular, we examine the financial error of neglecting nonlinear-
ities such as asymmetric borrowing and lending funding rates and by substituting
replacement close-out at default by the more stylized risk-free close-out assumption.
We analyze the large scale implications of nonlinearity of the valuation equations:
non-separability of risks, aggregation dependence in valuation, and local valuation
measures as opposed to universal ones. Finally, our numerical results confirm that
6 D. Brigo et al.

NVA and asymmetric funding rates can have a non-trivial impact on the valuation of
financial derivatives.
To summarize, the financial implications of our valuation framework are fourfold:
• Valuation is invariant to any theoretical risk-free rate and only based on observable
market rates.
• Valuation is a nonlinear problem under asymmetric funding and replacement close-
out at default, making funding and credit risks non-separable.
• Valuation is no longer bilateral because counterparties cannot observe each others’
liquidity policies nor their respective funding costs.
• Valuation is aggregation-dependent and portfolio values can no longer simply be
added up.
The above points stress the fact that we are dealing with values rather than prices.
By this, we mean to distinguish between the unique price of an asset in a complete
market with a traded risk-free bank account and the value a bank or market participant
attributes to the particular asset. Nevertheless, in the following, we will use the terms
price and value interchangeably to mean the latter. The paper is organized as follows.
Section 2 describes the general valuation framework with collateralized credit, debit,
liquidity, and funding valuation adjustments. Section 3 derives an iterative solution of
the pricing equation as well as a continuous-time approximation. Section 4 introduces
the nonlinearity valuation adjustment and provides numerical results for specific
valuation examples. Finally, Sect. 5 concludes the paper.

2 Trading Under Collateralization, Close-Out Netting,

and Funding Risk

In this section we develop a general risk-neutral valuation framework for OTC deriv-
ative deals. The section clarifies how the traditional pre-crisis derivative price is
consistently adjusted to reflect the new market realities of collateralization, counter-
party credit risk, and funding risk. We refer to the two parties of a credit-risky deal
as the investor or dealer (“I”) on one side and the counterparty or client (“C”) on the
other.
We now introduce the mathematical framework we will use. We point out that
the focus here is not on mathematics but on building the valuation framework. Full
mathematical subtleties are left for other papers and may motivate slightly different
versions of the cash flows, see for example Brigo et al. [15]. More details on the
origins of the cash flows used here are in Pallavicini et al. [33, 34].
Fixing the time horizon T ∈ R+ of the deal, we define our risk-neutral valuation
model on the probability space (Ω, G , (Gt )t∈[0,T ] , Q). Q is the risk-neutral proba-
bility measure ideally associated with the locally risk-free bank account numeraire
growing at the risk-free rate r . The filtration (Gt )t∈[0,T ] models the flow of informa-
tion of the whole market, including credit, such that the default times of the investor
τ I and the counterparty τC are G -stopping times. We adopt the notational convention
Nonlinearity Valuation Adjustment 7

that Et is the risk-neutral expectation conditional on the information Gt . Moreover,

we exclude the possibility of simultaneous defaults for simplicity and define the time
of the first default event among the two parties as the stopping time

τ  (τ I ∧ τC ).

In the sequel we adopt the view of the investor and consider the cash flows and
consequences of the deal from her perspective. In other words, when we price the
deal we obtain the value of the position to the investor. As we will see, with funding
risk this price will not be the value of the deal to the counterparty with opposite sign,
in general.
The gist of the valuation framework is conceptually simple and rests neatly on
the classical finance disciplines of risk-neutral valuation and discounting cash flows.
When a dealer enters into a derivatives deal with a client, a number of cash flows are
exchanged, and just like valuation of any other financial claim, discounting these cash
in- or outflows gives us a price of the deal. Post-crisis market practice includes four
(or more) different types of cash flow streams occurring once a trading position has
been entered: (i) Cash flows coming directly from the derivatives contract, such as
payoffs, coupons, dividends, etc. We denote by π(t, T ) the sum of the discounted cash
flows happening over the time period (t, T ] without including any credit, collateral,
and funding effects. This is where classical derivatives valuation would usually stop
and the price of a derivative contract with maturity T would be given by

Vt = Et [ π(t, T )] .

This price assumes no credit risk of the parties involved and no funding risk of
the trade. However, present-day market practice requires the price to be adjusted
by taking further cash-flow transactions into account: (ii) Cash flows required by
collateral margining. If the deal is collateralized, cash flows happen in order to
maintain a collateral account that in the case of default will be used to cover any
losses. γ (t, T ; C) is the sum of the discounted margining costs over the period
(t, T ] with C denoting the collateral account. (iii) Cash flows exchanged once a
default event has occurred. We let θτ (C, ε) denote the on-default cash-flow with ε
being the residual value of the claim traded at default. Lastly, (iv) cash flows required
for funding the deal. We denote the sum of the discounted funding costs over the
period (t, T ] by ϕ(t, T ; F) with F being the cash account needed for funding the
deal. Collecting the terms we obtain a consistent price V̄ of a derivative deal taking
into account counterparty credit risk, margining costs, and funding costs

V̄t (C, F) = Et π(t, T ∧ τ ) + γ (t, T ∧ τ ; C) + ϕ(t, T ∧ τ ; F) (1)

+1{t<τ <T } D(t, τ )θτ (C, ε) ,
τ
where D(t, τ ) = exp(− t rs ds) is the risk-free discount factor.
8 D. Brigo et al.

By using a risk-neutral valuation approach, we see that only the payout needs to
be adjusted under counterparty credit and funding risk. In the following paragraphs
we expand the terms of (1) and carefully discuss how to compute them.

2.1 Collateralization

The ISDA master agreement is the most commonly used framework for full and
flexible documentation of OTC derivative transactions and is published by the Inter-
national Swaps and Derivatives Association (ISDA [29]). Once agreed between two
parties, the master agreement sets out standard terms that apply to all deals entered
into between those parties. The ISDA master agreement lists two tools to mitigate
counterparty credit risk: collateralization and close-out netting. Collateralization of
a deal means that the party which is out-of-the-money is required to post collateral—
usually cash, government securities, or highly rated bonds—corresponding to the
amount payable by that party in the case of a default event. The credit support annex
(CSA) to the ISDA master agreement defines the rules under which the collateral
is posted or transferred between counterparties. Close-out netting means that in the
case of default, all transactions with the counterparty under the ISDA master agree-
ment are consolidated into a single net obligation which then forms the basis for any
recovery settlements.
Collateralization of a deal usually happens according to a margining procedure.
Such a procedure involves that both parties post collateral amounts to or withdraw
amounts from the collateral account C according to their current exposure on pre-
fixed dates {t1 , . . . , tn = T } during the life of the deal, typically daily. Let αi be
the year fraction between ti and ti+1 . The terms of the margining procedure may,
furthermore, include independent amounts, minimum transfer amounts, thresholds,
etc., as described in Brigo et al. [7]. However, here we adopt a general description
of the margining procedure that does not rely on the particular terms chosen by the
parties.
We consider a collateral account C held by the investor. Moreover, we assume
that the investor is the collateral taker when Ct > 0 and the collateral provider when
Ct < 0. The CSA ensures that the collateral taker remunerates the account C at an
accrual rate. If the investor is the collateral taker, he remunerates the collateral account
by the accrual rate ct+ (T ), while if he is the collateral provider, the counterparty
remunerates the account at the rate ct− (T ).2 The effective accrual collateral rate
c̃t (T ) is defined as

c̃t (T )  ct− (T )1{Ct <0} + ct+ (T )1{Ct >0} . (2)

2 We stress the slight abuse of notation here: A plus and minus sign does not indicate that the rates
are positive or negative parts of some other rate, but instead it tells which rate is used to accrue
interest on the collateral according to the sign of the collateral account.
Nonlinearity Valuation Adjustment 9

More generally, to understand the cash flows originating from collateralization of

the deal, let us consider the consequences of the margining procedure to the investor.
At the first margin date, say t1 , the investor opens the account and posts collateral
if he is out-of-the-money, i.e. if Ct1 < 0, which means that the counterparty is the
collateral taker. On each of the following margin dates tk , the investor posts collateral
according to his exposure as long as Ctk < 0. As collateral taker, the counterparty pays
interest on the collateral at the accrual rate ct−k (tk+1 ) between the following margin
dates tk and tk+1 . We assume that interest accrued on the collateral is saved into the
account and thereby directly included in the margining procedure and the close-out.
Finally, if Ctn < 0 on the last margin date tn , the investor closes the collateral account,
given no default event has occurred in between. Similarly, for positive values of the
collateral account, the investor is instead the collateral taker and the counterparty
faces corresponding cash flows at each margin date. If we sum up all the discounted
margining cash flows of the investor and the counterparty, we obtain
 

n−1
Ptk (tk+1 )
γ (t, T ∧ τ ; C)  1{ttk <(T ∧τ )} D(t, tk )Ctk 1 − c̃ , (3)
k=1
Ptk (tk+1 )

with the zero-coupon bond Ptc̃ (T )  [1 + (T − t)c̃t (T )]−1 , and the risk-free zero
coupon bond, related to the risk-free rate r , given by Pt (T ). If we adopt a first order
expansion (for small c and r ), we can approximate


n−1

γ (t, T ∧ τ ; C) ≈ 1{ttk <(T ∧τ )} D(t, tk )Ctk αk rtk (tk+1 ) − c̃tk (tk+1 ) , (4)
k=1

where with a slight abuse of notation we call c̃t (T ) and rt (T ) the continuously (as
opposed to simple) compounded interest rates associated with the bonds P c̃ and P.
This last expression clearly shows a cost of carry structure for collateral costs. If C
is positive to “I”, then “I” is holding collateral and will have to pay (hence the minus
sign) an interest c+ , while receiving the natural growth r for cash, since we are in a
risk-neutral world. In the opposite case, if “I” posts collateral, C is negative to “I”
and “I” receives interest c− while paying the risk-free rate, as should happen when
one shorts cash in a risk-neutral world.
A crucial role in collateral procedures is played by rehypothecation. We discuss
rehypothecation and its inherent liquidity risk in the following.
Rehypothecation
Often the CSA grants the collateral taker relatively unrestricted use of the collateral
for his liquidity and trading needs until it is returned to the collateral provider.
Effectively, the practice of rehypothecation lowers the costs of remuneration of the
provided collateral. However, while without rehypothecation the collateral provider
can expect to get any excess collateral returned after honoring the amount payable on
the deal, if rehypothecation is allowed the collateral provider runs the risk of losing a
fraction or all of the excess collateral in case of default on the collateral taker’s part.
10 D. Brigo et al.

We denote the recovery fraction on the rehypothecated collateral by R I when

the investor is the collateral taker and by RC when the counterparty is the collateral
taker. The general recovery fraction on the market value of the deal that the investor
receives in the case of default of the counterparty is denoted by RC , while R I is the
recovery fraction received by the counterparty if the investor defaults. The collateral
provider typically has precedence over other creditors of the defaulting party in
getting back any excess capital, which means R I  R I  1 and RC  RC  1. If
no rehypothecation is allowed and the collateral is kept safe in a segregated account,
we have that R I = RC = 1.

2.2 Close-Out Netting

In case of default, all terminated transactions under the ISDA master agreement with a
given counterparty are netted and consolidated into a single claim. This also includes
any posted collateral to back the transactions. In this context the close-out amount
plays a central role in calculating the on-default cash flows. The close-out amount is
the costs or losses that the surviving party incurs when replacing the terminated deal
with an economic equivalent. Clearly, the size of these costs will depend on which
party survives so we define the close-out amount as

ετ  1{τ =τC <τ I } ε I,τ + 1{τ =τ I <τC } εC,τ , (5)

where ε I,τ is the close-out amount on the counterparty’s default priced at time τ by
the investor and εC,τ is the close-out amount if the investor defaults. Recall that we
always consider the deal from the investor’s viewpoint in terms of the sign of the
cash flows involved. This means that if the close-out amount ε I,τ as measured by the
investor is positive, the investor is a creditor of the counterpaty, while if it is negative,
the investor is a debtor of the counterparty. Analogously, if the close-out amount εC,τ
to the counterparty but viewed from the investor is positive, the investor is a creditor
of the counterparty, and if it is negative, the investor is a debtor to the counterparty.
We note that the ISDA documentation is, in fact, not very specific in terms of
how to actually calculate the close-out amount. Since 2009, ISDA has allowed for
the possibility to switch from a risk-free close-out rule to a replacement rule that
includes the DVA of the surviving party in the recoverable amount. Parker and Mc-
Garry[35] and Weeber and Robson [40] show how a wide range of values of the
close-out amount can be produced within the terms of ISDA. We refer to Brigo et al.
[7] and the references therein for further discussions on these issues. Here, we adopt
the approach of Brigo et al. [7] listing the cash flows of all the various scenarios that
can occur if default happens. We will net the exposure against the pre-default value
of the collateral Cτ − and treat any remaining collateral as an unsecured claim.
If we aggregate all these cash flows and the pre-default value of collateral account,
we reach the following expression for the on-default cash-flow
Nonlinearity Valuation Adjustment 11

θτ (C, ε)  1{τ =τC <τ I } ε I,τ − LGDC (ε+ + +  − − +
I,τ − C τ − ) − LGDC (ε I,τ − C τ − ) (6)
 − − −  + + −
+ 1{τ =τ I <τC } εC,τ − LGD I (εC,τ − Cτ − ) − LGD I (εC,τ − Cτ − ) .

We use the short-hand notation X + := max(X , 0) and X − := min(X , 0), and

define the loss-given-default as LGDC  1 − RC , and the collateral loss-given-
default as LGDC  1 − RC . If both parties agree on the exposure, namely ε I,τ =
εC,τ = ετ , when we take the risk-neutral expectation in (1), we see that the price of
the discounted on-default cash-flow,

Et [1{t<τ <T } D(t, τ )θτ (C, ε)] =Et [1{t<τ <T } D(t, τ ) ετ ]
− CVA(t, T ; C) + DVA(t, T ; C), (7)

is the present value of the close-out amount reduced by the positive collateralized
CVA and DVA terms

Π CVAcoll (s) = LGDC (ε+ + +  − − +
I,s − C s − ) + LGDC (ε I,s − C s− ) ≥ 0,
 − − −  + + −
Π DVAcoll (s) = − LGD I (εC,s − Cs− ) + LGD I (εC,s − Cs− ) ≥ 0,

and
 
CVA(t, T ; C)  Et 1{τ =τC <T } D(t, τ )Π CVAcoll (τ ) ,
 
DVA(t, T ; C)  Et 1{τ =τ I <T } D(t, τ )Π DVAcoll (τ ) . (8)

Also, observe that if rehypothecation of the collateral is not allowed, the terms mul-
tiplied by LGDC and LGDI drop out of the CVA and DVA calculations.

2.3 Funding Risk

The hedging strategy that perfectly replicates the no-arbitrage price of a derivative
is formed by a position in cash and a position in a portfolio of hedging instruments.
When we talk about a derivative deal’s funding, we essentially mean the cash position
that is required as part of the hedging strategy, and with funding costs we refer to the
costs of maintaining this cash position. If we denote the cash account by F and the
risky asset account by H , we get

V̄t = Ft + Ht .

In the classical Black–Scholes–Merton theory, the risky part H of the hedge would
be a delta position in the underlying stock, whereas the locally risk-free (cash) part
F would be a position in the risk-free bank account. If the deal is collateralized,
the margining procedure is included in the deal definition insuring that funding of
12 D. Brigo et al.

the collateral is automatically taken into account. Moreover, if rehypothecation is

allowed for the collateralized deal, the collateral taker can use the posted collateral
as a funding source and thereby reduce or maybe even eliminate the costs of funding
the deal. Thus, we have the following two definitions of the funding account:
If rehypothecation of the posted collateral is allowed,

Ft  V̄t − Ct − Ht , (9)

and if such rehypothecation is forbidden, we have

Ft  V̄t − Ht . (10)

By implication of (9) and (10) it is obvious that if the funding account Ft > 0,
the dealer needs to borrow cash to establish the hedging strategy at time t. Corre-
spondingly, if the funding account Ft < 0, the hedging strategy requires the dealer to
invest surplus cash. Specifically, we assume the dealer enters a funding position on a
discrete time-grid {t1 , . . . , tm } during the life of the deal. Given two adjacent funding
times t j and t j+1 , for 1 ≤ j ≤ m − 1, the dealer enters a position in cash equal to
Ft j at time t j . At time t j+1 the dealer redeems the position again and either returns
the cash to the funder if it was a long cash position and pays funding costs on the
borrowed cash, or he gets the cash back if it was a short cash position and receives
funding benefits as interest on the invested cash. We assume that these funding costs
and benefits are determined at the start date of each funding period and charged at
the end of the period.
f˜
Let Pt (T ) represent the price of a borrowing (or lending) contract measurable
at t where the dealer pays (or receives) one unit of cash at maturity T > t. We
introduce the effective funding rate f˜t as a function: f˜t = f (t, F, H, C), assuming
that it depends on the cash account Ft , hedging account Ht , and collateral account
Ct . Moreover, the zero-coupon bond corresponding to the effective funding rate is
defined as
f˜
Pt (T )  [1 + (T − t) f˜t (T )]−1 ,

If we assume that the dealer hedges the derivatives position by trading in the spot
market of the underlying asset(s), and the hedging strategy is implemented on the
same time-grid as the funding procedure of the deal, the sum of discounted cash
flows from funding the hedging strategy during the life of the deal is equal to

ϕ(t, T ∧ τ ; F, H )
⎛ ⎞

m−1
Pt j (t j+1 ) Pt j (t j+1 )
= 1{tt j <(T ∧τ )} D(t, t j ) ⎝ Ft j − (Ft j + Ht j ) + Ht j ⎠
f˜ f˜
j=1 Pt j (t j+1 ) Pt j (t j+1 )
⎛ ⎞

m−1
Pt j (t j+1 )
= 1{tt j <(T ∧τ )} D(t, t j )Ft j ⎝1 − ⎠. (11)
f˜
j=1 Pt j (t j+1 )
Nonlinearity Valuation Adjustment 13

This is, strictly speaking, a discounted payout and the funding cost or benefit at time
t is obtained by taking the risk-neutral expectation of the above cash flows. For a
trading example giving more details on how the above formula for ϕ originates, see
Brigo et al. [15].
As we can see from Eq. (11), the dependence of hedging account dropped off
from the funding procedure. For modeling convenience, we can define the effective
funding rate f˜t faced by the dealer as

f˜t (T )  f t− (T )1{Ft <0} + f t+ (T )1{Ft >0} . (12)

A related framework would be to consider the hedging account H as being perfectly

collateralized and use the collateral to fund hedging, so that there is no funding cost
associated with the hedging account.
As with collateral costs mentioned earlier, we may rewrite the cash flows for
funding as a first order approximation in continuously compounded rates f˜ and r
associated to the relevant bonds. We obtain


m−1  
ϕ(t, T ∧ τ ; F) ≈ 1{tt j <(T ∧τ )} D(t, t j )Ft j α j rt j (t j+1 ) − f˜t j (t j+1 ) , (13)
j=1

We should also mention that, occasionally, we may include the effects of repo
markets or stock lending in our framework. In general, we may borrow/lend the cash
needed to establish H from/to our treasury, and we may then use the risky asset
in H for repo or stock lending/borrowing in the market. This means that we could
include the funding costs and benefits coming from this use of the risky asset. Here,
we assume that the bank’s treasury automatically recognizes this benefit or cost at
the same rate f˜ as used for cash, but for a more general analysis involving repo rate
h̃ please refer to, for example, Pallavicini et al. [34], Brigo et al. [15].
The particular positions entered by the dealer to either borrow or invest cash
according to the sign and size of the funding account depend on the bank’s liquidity
policy. In the following we discuss two possible cases: One where the dealer can
fund at rates set by the bank’s treasury department, and another where the dealer
goes to the market directly and funds his trades at the prevailing market rates. As a
result, the funding rates and therefore the funding effect on the price of a derivative
deal depends intimately on the chosen liquidity policy.
Treasury Funding
If the dealer funds the hedge through the bank’s treasury department, the treasury
determines the funding rates f ± faced by the dealer, often assuming average funding
costs and benefits across all deals. This leads to two curves as functions of maturity;
one for borrowing funds f + and one for lending funds f − . After entering a funding
position Ft j at time t j , the dealer faces the following discounted cash-flow

Φ j (t j , t j+1 ; F)  −Nt j D(t j , t j+1 ),

14 D. Brigo et al.

with
Ft−j Ft+j
Nt j  f−
+ f+
.
Pt j (t j+1 ) Pt j (t j+1 )

Under this liquidity policy, the treasury—and not the dealer himself—is in charge of
debt valuation adjustments due to funding-related positions. Also, being entities of
the same institution, both the dealer and the treasury disappear in case of default of
the institution without any further cash flows being exchanged and we can neglect
the effects of funding in this case. So, when default risk is considered, this leads to
following definition of the funding cash flows

Φ̄ j (t j , t j+1 ; F)  1{τ >t j } Φ j (t j , t j+1 ; F).

Thus, the risk-neutral price of the cash flows due to the funding positions entered at
time t j is
 
  Pt j (t j+1 ) Pt j (t j+1 )
Et j Φ̄ j (t j , t j+1 ; F) = −1{τ >t j } Ft−j f−
+ Ft+j f+
.
Pt j (t j+1 ) Pt j (t j+1 )

If we consider a sequence of such funding operations at each time t j during the life
of the deal, we can define the sum of cash flows coming from all the borrowing and
lending positions opened by the dealer to hedge the trade up to the first-default event


m−1   
ϕ(t, T ∧ τ ; F)  1{t t j <(T ∧τ )} D(t, t j ) Ft j + Et j Φ̄ j (t j , t j+1 ; F) (14)
j=1
⎛ ⎞

m−1
P t (t ) P t (t )
1{t t j <(T ∧τ )} D(t, t j ) ⎝ Ft j − Ft−j − Ft+j
j+1 j+1
=
j j
⎠.
f− f+
j=1 Pt j (t j+1 ) Pt j (t j+1 )

In terms of the effective funding rate, this expression collapses to (11).

Market Funding
If the dealer funds the hedging strategy in the market—and not through the bank’s
treasury—the funding rates are determined by prevailing market conditions and are
often deal-specific. This means that the rate f + the dealer can borrow funds at
may be different from the rate f − at which funds can be invested. Moreover, these
rates may differ across deals depending on the deals’ notional, maturity structures,
dealer-client relationship, and so forth. Similar to the liquidity policy of treasury
funding, we assume a deal’s funding operations are closed down in the case of default.
Furthermore, as the dealer now operates directly on the market, he needs to include
a DVA due to his funding positions when he marks-to-market his trading books. For
simplicity, we assume that the funder in the market is default-free so no funding CVA
Nonlinearity Valuation Adjustment 15

needs to be accounted for. The discounted cash-flow from the borrowing or lending
position between two adjacent funding times t j and t j+1 is given by

Φ̄ j (t j , t j+1 ; F)  1{τ >t j } 1{τ I >t j+1 } Φ j (t j , t j+1 ; F)

− 1{τ >t j } 1{τ I <t j+1 } (LGD I ε− F,τ I − ε F,τ I )D(t j , τ I ),

where ε F,t is the close-out amount calculated by the funder on the dealer’s default

ε F,τ I  −Nt j Pτ I (t j+1 ).

To price this funding cash-flow, we take the risk-neutral expectation

 
  Pt j (t j+1 ) Pt j (t j+1 )
Et j Φ̄ j (t j , t j+1 ; F) = −1{τ >t j } Ft−j f−
+ Ft+j f+
.
Pt j (t j+1 ) P̄t j (t j+1 )

f+
Here, the zero-coupon funding bond P̄t (T ) for borrowing cash is adjusted for the
dealer’s credit risk
f+
f+ Pt (T )
P̄t (T )  T  ,
Et LGD I 1{τ I >T } + R I

where the expectation on the right-hand side is taken under the T -forward measure.
Naturally, since the seniority could be different, one might assume a different recov-
ery rate on the funding position than on the derivatives deal itself (see Crépey [21]).
Extensions to this case are straightforward.
Next, summing the discounted cash flows from the sequence of funding operations
through the life of the deal, we get a new expression for ϕ that is identical to (14)
f+ f+
where the Pt (T ) in the denominator is replaced by P̄t (T ). To avoid cumbersome
+
notation, we will not explicitly write P̄ f in the sequel, but just keep in mind that
+
when the dealer funds directly in the market then P f needs to be adjusted for funding
DVA. Thus, in terms of the effective funding rate, we obtain (11).

3 Generalized Derivatives Valuation

In the previous section we analyzed the discounted cash flows of a derivatives trade
and we developed a framework for consistent valuation of such deals under collater-
alized counterparty credit and funding risk. The arbitrage-free valuation framework
is captured in the following theorem.

Theorem 1 (Generalized Valuation Equation)

The consistent arbitrage-free price V̄t (C, F) of a contingent claim under counter-
party credit risk and funding costs takes the form
16 D. Brigo et al.

V̄t (C, F) = Et π(t, T ∧ τ ) + γ (t, T ∧ τ ; C) + ϕ(t, T ∧ τ ; F) (15)

+1{t<τ <T } D(t, τ )θτ (C, ε) ,

where
1. π(t, T ∧ τ ) is the discounted cash flows from the contract’s payoff structure up to
the first-default event.
2. γ (t, T ∧ τ ; C) is the discounted cash flows from the collateral margining proce-
dure up to the first-default event and is defined in (3).
3. ϕ(t, T ∧ τ ; F) is the discounted cash flows from funding the hedging strategy
up to the first-default event and is defined in (11).
4. θτ (C, ε) is the on-default cash-flow with close-out amount ε and is defined in (6).
Note that in general a nonlinear funding rate may lead to arbitrages since the choice
of the martingale measure depends on the funding/hedging strategy (see Remark 4.2).
One has to be careful in order to guarantee that the relevant valuation equation admits
solutions. Existence and uniqueness of solutions in the framework of this paper are
discussed from a fully mathematical point of view in Brigo et al. [15], a version of
which, from the same authors, appears in this volume.
In general, while the valuation equation is conceptually clear—we simply take
the expectation of the sum of all discounted cash flows of the trade under the risk-
neutral measure—solving the equation poses a recursive, nonlinear problem. The
future paths of the effective funding rate f˜ depend on the future signs of the funding
account F, i.e. whether we need to borrow or lend cash on each future funding
date. At the same time, through the relations (9) and (10), the future sign and size
of the funding account F depend on the adjusted price V̄ of the deal which is the
quantity we are trying to compute in the first place. One crucial implication of this
nonlinear structure of the valuation problem is the fact that FVA is generally not just
an additive adjustment term, as often assumed. More importantly, we see that the
celebrated conjecture identifying the DVA of a deal with its funding benefit is not fully
general. Only in the unrealistic setting where the dealer can fund an uncollateralized
trade at equal borrowing and lending rates, i.e. f + = f − , do we achieve the additive
structure often assumed by practitioners. If the trade is collateralized, we need to
impose even further restrictions as to how the collateral is linked to the price of the
trade V̄ . It should be noted here that funding DVA (as referred to in the previous
section) is similar to the DVA2 in Hull and White [28] and the concept of “windfall
funding benefit at own default” in Crépey [22, 23]. In practice, however, funds
transfer pricing and similar operations conducted by banks’ treasuries clearly weaken
the link between FVA and this source of DVA. The DVA of the funding instruments
does not regard the bank’s funding positions, but the derivatives position, and in
general it does not match the FVA mainly due to the presence of funding netting sets.
Remark 1 (The Law of One Price.)
On the theoretical side, the generalized valuation equation shakes the foundation of
the celebrated Law of One Price prevailing in classical derivatives pricing. Clearly,
if we assume no funding costs, the dealer and counterparty agree on the price of
Nonlinearity Valuation Adjustment 17

the deal as both parties can—at least theoretically—observe the credit risk of each
other through CDS contracts traded in the market and the relevant market risks, thus
agreeing on CVA and DVA. In contrast, introducing funding costs, they will not agree
on the FVA for the deal due to asymmetric information. The parties cannot observe
each others’ liquidity policies nor their respective funding costs associated with a
particular deal. As a result, the value of a deal position will not generally be the same
to the counterparty as to the dealer just with opposite sign.

Finally, as we adopt a risk-neutral valuation framework, we implicitly assume

the existence of a risk-free interest rate. Indeed, since the valuation adjustments are
included as additional cash flows and not as ad-hoc spreads, all the cash flows in (15)
are discounted by the risk-free discount factor D(t, T ). Nevertheless, the risk-free
rate is merely an instrumental variable of the general valuation equation. We clearly
distinguish market rates from the theoretical risk-free rate avoiding the dubious claim
that the over-night rates are risk free. In fact, as we will show in continuous time, if
the dealer funds the hedging strategy of the trade through cash accounts available to
him—whether as rehypothecated collateral or funds from the treasury, repo market,
etc.—the risk-free rate vanishes from the valuation equation.

3.1 Discrete-Time Solution

Our purpose here is to turn the generalized valuation equation (15) into a set of
iterative equations that can be solved by least-squares Monte Carlo methods. These
methods are already standard in CVA and DVA calculations (Brigo and Pallavicini
[5]). To this end, we introduce the auxiliary function

π̄ (t j , t j+1 ; C)  π(t j , t j+1 ∧ τ ) + γ (t j , t j+1 ∧ τ ; C)

+ 1{t j <τ <t j+1 } D(t j , τ )θτ (C, ε) (16)

which defines the cash flows of the deal occurring between time t j and t j+1 adjusted
for collateral margining costs and default risks. We stress the fact that the close-
out amount used for calculating the on-default cash flow still refers to a deal with
maturity T . If we then solve valuation equation (15) at each funding date t j in the
time-grid {t1 , . . . , tn = T }, we obtain the deal price V̄ at time t j as a function of the
deal price on the next consecutive funding date t j+1
 
V̄t j = Et j V̄t j+1 D(t j , t j+1 ) + π̄ (t j , t j+1 ; C)
 
−
Pt j (t j+1 ) +
Pt j (t j+1 )
+ 1{τ >t j } Ft j − Ft j f − − Ft j f + ,
Pt j (t j+1 ) Pt j (t j+1 )

where, by definition, V̄tn  0 on the final date tn . Recall the definitions of the funding
account in (9) if no rehypothecation of collateral is allowed and in (10) if rehypothe-
18 D. Brigo et al.

cation is permitted, we can then solve the above for the positive and negative parts of
the funding account. The outcome of this exercise is a discrete-time iterative solution
of the recursive valuation equation, provided in the following theorem.

Theorem 2 (Discrete-time Solution of the Generalized Valuation Equation)

We may solve the full recursive valuation equation in Theorem 1 as a set of backward-
iterative equations on the time-grid {t1 , . . . , tn = T } with V̄tn  0. For τ < t j , we
have
V̄t j = 0,

while for τ > t j , we have

(i) if rehypothecation is forbidden:
  ±
 ± f˜ t π̄ (t j , t j+1 ; C) − Ht j
V̄t j − Ht j = Pt j (t j+1 ) Et j+1 V̄t j+1 + ,
j
D(t j , t j+1 )

(ii) if rehypothecation is allowed:

(V̄t j − Ct j −Ht j )±
  ±
f˜ t π̄ (t j , t j+1 ; C) − Ct j − Ht j
= Pt j (t j+1 ) Et j+1 V̄t j+1 + ,
j
D(t j , t j+1 )

where the expectations are taken under the Qt j+1 -forward measure.

The ± sign in the theorem is supposed to stress the fact that the sign of the funding
account, which determines the effective funding rate, depends on the sign of the
conditional expectation. Further intuition may be gained by going to continuous
time, which is the case we will now turn to.

3.2 Continuous-Time Solution

Let us consider a continuous-time approximation of the general valuation equation.

This implies that collateral margining, funding, and hedging strategies are executed
in continuous time. Moreover, we assume that rehypothecation is allowed, but similar
results hold if this is not the case. By taking the time limit, we have the following
expressions for the discounted cash flow streams of the deal
 T ∧τ
π(t, T ∧ τ ) = π(s, s + ds)D(t, s),
t
 T ∧τ
γ (t, T ∧ τ ; C) = (rs − c̃s )Cs D(t, s)ds,
t
Nonlinearity Valuation Adjustment 19
 T ∧τ
ϕ(t, T ∧ τ ; F) = (rs − f˜s )Fs D(t, s)ds,
t

where as mentioned earlier π(t, t + dt) is the pay-off coupon process of the derivative
contract and rt is the risk-free rate. These equations can also be immediately derived
by looking at the approximations given in Eqs. (4) and (13).
Then, putting all the above terms together with the on-default cash flow as in
Theorem 1, the recursive valuation equation yields
 T  
V̄t = Et 1{s<τ } π(s, s + ds) + 1{τ ∈ds} θs (C, ε) D(t, s)
t
 T  
+ Et 1{s<τ } (rs − c̃s )Cs D(t, s) ds (17)
t
 T  
+ Et 1{s<τ } (rs − f˜s )Fs D(t, s)ds.
t

By recalling Eq. (7), we can write the following

Proposition 1 The value V̄t of the claim under credit gap risk, collateral, and fund-
ing costs can be written as

V̄t = Vt − CVAt + DVAt + LVAt + FVAt (18)

where Vt is the price of the deal when there is no credit risk, no collateral, and no fund-
ing costs; LVA is a liquidity valuation adjustment accounting for the costs/benefits
of collateral margining; FVA is the funding cost/benefit of the deal hedging strategy,
and CVA and DVA are the familiar credit and debit valuation adjustments after col-
lateralization. These different adjustments can be obtained by rewriting (17). One
gets
 T   
Vt = Et D(t, s)1{τ >s} π(s, s + ds) + 1{τ ∈ds} εs (19)
t

and the valuation adjustments

  
T  
CVAt = − E D(t, s)1{τ >s} − 1{s=τC <τ I } Π CVAcoll (s) du
t
  
T  
DVAt = E D(t, s)1{τ >s} 1{s=τ I <τC } Π DVAcoll (s) du
t
 T  
LVAt = Et D(t, s)1{τ >s} (rs − c̃s )Cs ds
t
  
T  
FVAt = ˜
E D(t, s)1{τ >s} (rs − f s )Fs ds
t
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 The Milanaus occupy the mouths of the Rejang, the Ova, the
Muka, the Bintulu, and various lesser streams.
The tattooed races, as the Kanowits, Pakatans, Punans, and
others, live towards the interior of the districts lying between the
Rejang and the Bintulu, and border on the Kayans, who occupy the
Balui country as the interior of the Bintulu and the Rejang is called.
All these groups of tribes speak separate languages, and each
has also various dialects.
It is very difficult to obtain even an approximate estimate of the
amount of population, but I will state it at the most moderate rate.
The home districts, as Lundu, Sarawak, Samarahan, Sadong, and 80,000
Sibuynu, may be reckoned at
The Sea Dayak districts, including Batang Lupar, Seribas, Kalaka, and 120,000
those on the left bank of the Rejang, at
The districts lying between Rejang Mouth and Bintulu 40,000
Total 240,000

In stating these numbers I am convinced that I am very much

underrating them, as the more inquiries we make the thicker appears
the population of the Sea Dayak districts.
The capital of Sarawak is Kuching, and, considering the
circumstances of the country, the rise of this free port has been
rapid. When Sir James Brooke first reached the spot, there were few
inhabitants except the Malay rajahs and their followers, who
subsequently for the most part removed to Brunei, the residence of
the sultan. I saw Kuching in the year 1848, when it was but a small
place, with few Chinese or Kling shops, and perhaps not over 6,000
Malay inhabitants; there was little trade, the native prahus were
small, and I saw some few of them. The jungle surrounded the town
and hemmed in the houses, and the Chinese gardeners had
scarcely made an impression on the place. As confidence was
inspired, so the town increased, and now, including the outlying
parishes, its population numbers not less than 15,000.
The commerce of the place has kept pace with it, and from a rare
schooner finding its way over to return with a paltry cargo, the trade
has risen till an examination of the books convinced me that it was in
1860 above 250,000l. of exports and imports.
The articles constituting the exports are for the most part the
produce of the jungle; the principal exception is sago, which is
imported from the districts to the east of Cape Sirik, to be
manufactured at Kuching into the sago-pearl and flour of commerce.
The trade in this article has for many years been injured by the
constant disturbances, ending in a state of chronic civil war, which
desolated the producing districts. Now, however, that they have been
ceded to Sarawak, and a firm government established, a great
development should take place in this branch of trade.
An article which might become of great value is cotton: it is
cultivated among many of the tribes residing within the Sarawak
territories, particularly by the Dayaks of Seribas and Sakarang, who
manufacture from it a durable cloth. The Cotton Supply Association
is sending out some Egyptian seed, which, if it arrive in good
condition, may tend to increase the produce. I am convinced,
however, that no cultivation will have great success in Borneo which
does not at first depend on imported labour, and as China is near,
the supply could be easily and regularly obtained.
The amount of rice produced will also greatly depend on imported
labour; at present the natives but rarely export any, and during some
seasons scarcely produce sufficient for the consumption of the
people. There is one thing to be observed, however, that as the
country is becoming year by year more settled, the inhabitants in the
same ratio give greater attention to acquiring wealth. The Sea
Dayaks are very acquisitive, and would soon imitate the Chinese
methods of cultivation. I have elsewhere remarked that the
agriculture to the north of the capital is far superior to anything found
in Sarawak or its neighbourhood, and this has most probably arisen
from the large number of Chinese who formerly inhabited that
country.
The use of the plough, the harrow, or the buffalo in cultivation is,
except by report, entirely unknown in Sarawak; the natives will, I
believe, be much surprised at the results produced by a good
English plough, which is about to be tried on some fields of sugar-
cane in the neighbourhood of Kuching, and it may do much good by
showing them the methods employed by other nations. At present
the Malays and Dayaks use no other instruments than a long
chopper, an axe, and a pointed stick.
The soil and the varied heights on the hill-sides, would render
Sarawak a fine country for coffee; which grows freely, and so do
pepper, tapioca, arrowroot, and almost every product cultivated in
the neighbouring islands; but these things are not yet grown in
sufficient quantities to render them worth mentioning as articles of
export. Of the jungle produce I may name the principal: they are fine
timber of many varieties, gutta-percha, india-rubber, wax, and
rattans, and the last are to be obtained in the very greatest
abundance and of the best quality in the districts lately ceded by the
sultan to the government of Sarawak.
Sarawak has a very great advantage over many countries, having
water communication from the far interior, down to her coasts, and
inner channels communicating with many of the outlying districts.
The mineral products known to exist in sufficient quantities to be
worth working are not numerous; they are coal, antimony, and gold.
Coal seams have long been known to exist, but in situations that
necessitated a considerable outlay; within the last few months,
however, coal has been discovered close to the water’s edge in the
districts lately ceded, but I have not yet heard of the result of the
examinations which have just been made. Antimony of the best
quality can be procured in sufficient quantities to supply any
demand, and a new mine has been secured to the Sarawak
government by the cession of Bintulu.
Gold is only worked by the Chinese, who wash the surface earth
in a way which I will afterwards describe. No deep sinkings have
been attempted, nor has quartz yet been discovered in large
quantities, and it is not likely to be while nine-tenths of the country
are still clothed with forest.
Indications of many minerals exist, but until found in greater
quantities they are scarcely worth referring to, except to encourage a
careful examination of the mountain and hilly districts. Sufficient
silver has however been found to render it probable that a mine
exists not far from the Bidi antimony works. The Dutch beyond the
border are said to be working a copper mine to great profit; and in
Sarawak indications of that mineral, as well as of lead, have been
several times discovered: but no great importance can be attached
to them at present. Manganese and arsenic have been found in
considerable quantities, but they are not yet worked.
The most remarkable thing connected with Sarawak is the change
which has come over the aborigines; from all the accounts I could
gather they were twenty-five years ago in a much more miserable
condition than the Muruts and Bisayas in the neighbourhood of the
capital. The country was in a state of complete anarchy, and Malays
were fighting against Malays and Dayaks against Dayaks. Even
before the civil war broke out the condition of the latter was
miserable in the extreme; they were exposed to every exaction, their
children were taken from them, their villages attacked and often
sacked by the Seribas and Sakarang, and hunger approaching to
famine added to their troubles.
Even when Sir James Brooke succeeded to the government and
peace was restored, it took years to eradicate the belief, founded on
long established practice, that the Dayaks were persons to be
plundered by every means. When it could not be done openly, it was
carried on by a system of forced trade. Sir James Brooke’s attention
was constantly directed to this subject, and he found that as long as
the Malay chiefs were paid their salaries by receiving half the rice-
tax, some of them had an excuse for continuing the old practice. I
have mentioned the tours of inspection undertaken under his
direction by his nephew, Captain Brooke; shortly after these were
concluded a new system was introduced, and the chiefs had their
salaries paid to them in money. Since which time few complaints
have been made by the Dayaks.
As far as material comfort adds to the happiness of man, the
Dayaks have reason to be thankful: whatever they earn, they enjoy;
a tax of four shillings on every family is the amount levied on them by
government: after that is paid they are free from every exaction. Not
only have they the produce of their industry, but the wealth derived
from their forests of fruit-trees, a market for which can always be
found among the Chinese and Malays. Many of the caves likewise
produce the edible bird’s nest, which is another source of profit.
The Malays, however, have benefited equally with the Dayaks by
the change of system. Formerly the chiefs employed a crowd of
relations and followers to collect their taxes and to oppress the
aborigines; and, as at Brunei now, if the master asked for a bushel of
rice, the man demanded two more for himself. The system had a
debasing influence on all; no doubt many suffered a little by the
change, but as a rule all these men turned to legitimate trade, as
soon as they found that to oppress the Dayaks entailed fines and
punishments.
The impetus given was great, trading prahus were built, and
voyages undertaken which their fathers had not thought of.
Singapore, Java, the Malay Peninsula, and even a portion of
Sumatra were visited. This brought wealth and increased activity,
which was shown in the improved dwellings, the larger prahus, the
gayer dresses, and the amount of gold ornaments that became
common among their women.
There is one thing I must particularly mention, the remarkable
honesty shown by these traders in all their intercourse with
Europeans. An Englishman, who greatly facilitated their commercial
transactions by loans of money at a rate of interest which in the East
was considered remarkably moderate, told me that, in all his
experience, he had only found one Malay who attempted to cheat
him. He never demanded receipts, but simply made an entry in his
book, and his loans with that one exception were all repaid him.
He told me a story of a Malay trader that singularly illustrates their
character. The man borrowed a small sum and went on a voyage; in
a month he returned, stating he had lost both prahu and cargo, and
asked to be entrusted with double the amount of his former debt; it
was given him. Again he returned, having been wrecked close to the
mouth of the river. He came to this Englishman and clearly explained
his misfortune, but added—“You know I am an honest man, disasters
cannot always happen to me, lend me sufficient to go on another
voyage, and I will repay all I owe you.” My informant said he
hesitated, but at last lent him the whole amount demanded. The
trader was away three months, and his smiling face, when he came
back to his creditor, showed he had been successful; he paid off the
principal portion of the debt, and afterwards cleared off the
remainder, and was, when I heard the story, one of the most
flourishing traders in Sarawak. I thought the anecdote was
honourable to both, and illustrates the kindly feeling that exists in
that country between the European and native.
This confidence, however, was the growth of some years, and the
result of the system of government which I will now describe. In
treating of the capital, I have shown the practice established there. In
all the former dependencies of Brunei there were local chiefs who
administered the internal affairs of their own districts. In Sarawak
there were originally three, and that number Sir James Brooke
continued in their employment, and permitted and encouraged them
to take part in everything connected with the government of the
country, obtaining their consent to the imposition of any new tax or
change in the system of levying the old, consulting them on all
occasions and allowing their local knowledge to guide him in those
things with which they were necessarily better acquainted than he
could possibly be.
It was not to be expected that his teaching and influence should
suddenly change these men, accustomed to almost uncontrolled
sway, into just and beneficent rulers, and he failed in moulding the
datu patiñggi, the principal chief. As long as Sir James Brooke was
himself present in Sarawak, he could keep him tolerably straight; but
no amount of liberality could prevent him oppressing the Dayaks on
every possible occasion. His rapacity increasing, he took bribes in
his administration of justice, and it was at last found necessary to
remove him. The third chief behaved much better, and the second,
patiñggi Ali, was killed during one of Captain Keppel’s expeditions.
The last named left many sons, two of whom would have adorned
any situation in life; the eldest, the late bandhar of Sarawak, was a
kind, just, and good man, respected in his public capacity, and
beloved in all social intercourse: his only fault was, a certain want of
decision, partly caused by a rapid consumption that carried him off
about two years since. His next brother succeeded him, and appears
to have all his brother’s good qualities, with remarkable firmness of
character. In fact, a generation is springing up, with new ideas and
more enlarged views, who appear to appreciate the working of their
present government, and have a pride in being connected with it.
By associating these men in the administration, and thus
educating them in political life, and by setting the example of a great
equality in social intercourse, Sir James Brooke laid the foundation
of a government which stood a shock that many of his best friends
expected would prove fatal. I mean the Chinese insurrection. None
of the predicted results have followed. Trade and revenue have both
actually increased, and a much better system of management has
been introduced.
The example set in the capital is followed in all the dependent
districts, and the local rulers are always associated with the
European in the government. The effect has been to prevent any
jealousy arising; and the contempt of all natives, which appears a
part of our creed in many portions of our empire, is not felt in
Sarawak. Nothing appears more striking to those who have resided
long in Sarawak than the extraordinary change which appears to
have been effected in the character of the people, and also in that of
individuals. There is no doubt that Sir James Brooke was working in
soil naturally good, or these results could not have taken place, but
yet when we know the previous history of men, how lawless and
savage they were, and yet find they have conducted themselves in
an exemplary manner for twenty years, the whole circumstances
appear surprising.
I will tell an anecdote of one of the very oldest of the chiefs, to
show the apparently stubborn materials which had to be moulded.
The man relating the story himself, said that about thirty-five years
ago he was cruising near Datu Point when he observed a small
trading boat passing out at sea. He immediately gave chase, and
when near her noticed the crew were all armed, and preparing to
defend themselves, so his own followers advised him to sheer off,
but he made them push alongside, and springing on board the
trading prahu with a drawn kris so effectually alarmed the hostile
crew that they all ran below. There were six of them, but he killed
them all, and added, one only did he pity, as in their distress five
called on their mothers, but one only begged mercy of God. And yet
that man has behaved well for the last twenty-five years, and much
better, in my opinion, than many others of far greater pretensions. It
never appears to strike him that he had committed a bloodthirsty and
wicked action, perhaps he considered that to conceal his piratical act
any means were justifiable; but however that may be, he has
completely changed his conduct, has been faithful under great
temptations, and has always proved himself a brave and trustworthy
man since a regular government has been established in Sarawak.
Few would have undertaken the responsibility of ruling a country
with such materials, but to render the task easier, there were some
excellent men to leven the multitude, and a retired pirate is generally
a good servant, if you can turn the energies that led him to a roving
life into a legitimate channel.
It is obvious, however, that where a government depends for its
stability on the individual character of its officers, and where a
change in the system may be introduced by the head of the
government not following in the footsteps of his predecessors, men
will not risk their capital in the development of the country.
I have watched the gradual development of Sarawak with the
greatest interest; I have seen districts once devoted to anarchy
restored to prosperity and peace by the simple support of the orderly
part of the population by a government acting with justice, and it is
not surprising that all its neighbours appeal to it, when their own
countrymen are seen to exercise so great an influence in its
councils.
The experiment so happily begun might be carried on with great
results, had the Sarawak government more material force to back it.
At present nine-tenths of the country are forest; I believe the largest
portion of that may be cultivated with great success, but population is
wanting. There is but one people who can develope the islands of
the Eastern Archipelago, and they are the Chinese.
They are a most industrious and saving nation, and yet liberal in
their households, and free in their personal expenses. They are the
only people to support an European government, as they are the
only Asiatics who will pay a good revenue. In Sarawak there are not
above 3,000 Chinese, and yet they pay in indirect taxes more than
the quarter of a million of Malays and Dayaks pay altogether. There
is room within the Sarawak territories for half a million of Chinese
cultivators, without in any way inconveniencing the other inhabitants;
and these Chinese could pay without feeling the pressure 2l. a head
in indirect taxes: as those levied on opium, spirits, tobacco, and
other articles.
There must be soundness in the system pursued in Sarawak, or it
could not have stood alone for so many years, exposed as it has
been to successive storms. A similar, or a modified system,
supported by our national power, would produce great results. No
one can judge of the consuming power of the Chinese abroad, by
the Chinese in their own country. Abroad he clothes himself in
English cloth, he uses English iron; he sometimes takes to our
crockery; he when well off drinks our beer, and is especially partial to
our biscuits. He does nothing in a niggardly spirit, but, as I have said,
is liberal in his household.
I believe if England were to try the experiment of a Chinese
colony, where they had room to devote themselves to agriculture, to
mining, and to commerce, the effects would be as great in proportion
as those displayed in our Australian colonies. The Indian Isles are
not far distant from China, and emigrants from them are always
ready to leave on the slightest temptation.
I have lived so many years in the Archipelago that I hope my
information may be found correct. I certainly expect much from the
future of Borneo, if the present experiment should be aided or
adopted, as it possesses the elements of wealth and prosperity, and
can obtain what is essential to success, a numerous and industrious
population.
 The Chinese have no difficulty in amalgamating with the native
inhabitants, and to a certain extent can always obtain wives, as
Borneo, like England, appears to possess a redundant female
population. The men are, of course, exposed to many more dangers
than the women, and these latter are so fond of their own homes that
they seldom remove far from their parents. But now there appears to
be no difficulty in procuring female emigrants, and if the present
rebellion continue to desolate China we might remove all the
inhabitants of a village together. I have heard men say that they have
seen as much misery in some of the provinces of that vast empire as
they saw in Ireland during the famine, and when that is the case,
there will be no difficulty in inducing these people to emigrate. A
calculation has been made that, if Borneo were well cultivated, it
would suffice for the support of a hundred millions of Chinese.
The administration of justice is a subject of vital importance in all
countries, but especially so in an Asiatic and a mixed population.
The simple forms adopted in Sarawak are admirably suited to the
country, and the care displayed in inquiries has won the confidence
of the people. There are three courts established in Sarawak: a
general court, a police court, and a native religious court. The last
has charge of all cases in which a reference is required to the laws
of the Koran, as in marriages and divorces; an appeal lies, however,
in certain cases to the general court. Ten years ago the native judges
gave no satisfaction to the people and inspired no confidence, as it
was known the principal chief took bribes, but since his removal, it is
rare indeed to hear of a decision giving dissatisfaction, as both the
late bandhar and his brother, the present bandhar, really take a pride
in their court, and look into the cases. They also regularly attend the
general court, and have thus been educated by the example set by
the English magistrates of the most patient investigation. The
general court takes cognizance of all the principal cases both civil
and criminal, and in serious trials there is a kind of jury of the
principal English and native inhabitants.
Cheap, and above all, speedy justice is what is required in the
East, where they never can understand our wearisome forms. It
reminds me of the Malay tried for murder in one of our English
courts; he was asked the question, Guilty or Not guilty, and
answered immediately, Guilty. He was advised to withdraw it and
plead not guilty, but he steadily refused, saying, “Why should I plead
not guilty, when I know I committed the murder; when you all know
that as well as I, and mean to hang me, so don’t make a long fuss
about it.” They very often confess even the most heinous crimes.
The police court has cognizance of the same cases as would come
before similar courts elsewhere, with a little mixture of the county
court.
The Malays, except the followers of the Brunei nobles, are found
on the whole to be very truthful, faithful to their relatives, and
devotedly attached to their children. Remarkably free from crimes,
and when they commit them it is generally from jealousy. Brave
when well led, they inspire confidence in their commanders; highly
sensitive to dishonour, and tenacious as to the conduct of their
countrymen towards them, and remarkably polite in their manners,
they render agreeable all intercourse with them. Malays are
generally accused of great idleness; in one sense they deserve it;
they do not like continuous work, but they do enough to support
themselves and families in comfort, and real poverty is unknown
among them. No relative is abandoned because he is poor, or
because an injury or an illness may have incapacitated him for work.
I like the Malays, although I must allow that I became weary of
having only them with whom to associate.
Sarawak appears to the natives of the western coast of Borneo
what an oasis must be to the wandering Arab, and it is often visited
by the people of the neighbouring countries to examine as a sort of
curiosity. A party of Bugau Dayaks from the upper Kapuas once
arrived in Kuching after fifteen days’ journey, merely to discover
whether or not it were true that the Dayaks of Sarawak were living in
comfort; but a more curious incident was the arrival of a chief from
the Natunas to lay his case before the Sarawak government. A near
relative of the Sultan of Linggin had yearly visited that group, which
was subject to his authority, under the pretence of collecting taxes,
but instead of confining himself to that, commenced a system of
gross extortion. The natives submitted patiently, but not content with
that, he seized their young girls, and when his passions were
satisfied, sent them again ashore, and forbad them to marry, under
the pretence that they must consider themselves in future as his
concubines.
At last he proceeded so far as, during a chiefs absence, to take
up his residence in his house and to seize on his wife and family. On
the orang kaya’s return, he was received with shots from his own
batteries. His wife, evading the watch kept on her, rejoined him; but
after vainly endeavouring to recover the rest of his family, he brought
his complaints to Sarawak. As the Sultan of Linggin was under the
suzerainty of the Dutch, it was impossible to interfere actively in their
defence; but as there was no doubt of the truth of these
representations, as they merely confirmed the accounts which had
been previously received from the officers of one of our vessels
which had surveyed that group, the whole case was laid before the
Dutch authorities at Rhio, with an apology for the apparent
interference in their affairs; but although naturally disposed to think
that there was much exaggeration in the native accounts, they acted
promptly, sent a vessel of war to the Natunas, whose captain fully
confirmed the report forwarded, and giving the young noble an order
to restore all his plunder, and come on board within an hour, they set
sail with him to one of the fortresses to the eastward, where he
remained several years. This energetic action had a most beneficial
effect, and, although many years have passed since, I have not
heard of any complaints from the inhabitants of that very lovely
group.
The relatives of the Sultan of Linggin acted in the same way as
the Bornean nobles, who really appear to be convinced that they
have a right to treat the poorer natives as they please, and do not
understand any other method, but Makota’s cruel nature delighted in
it for its sake. He used to say, “I know that the system of government
pursued in Sarawak is the right system, and that in the end we
should obtain much more from them by treating them kindly; but I
have been accustomed all my life to oppress them, and it affords me
unmixed satisfaction to get even their cooking-pots from them;” and
he chuckled over the remembrance.
 As the Malays increase in wealth, they are gradually taking more
to the fashion of making pilgrimages to Mecca, though the sufferings
they undergo in the crowded ships are almost equal to those
endured in the middle passage. Some of the Arab ships are so
crammed, that each pilgrim is only allowed sufficient space for a
small mat on the deck, and there he remains during the whole
voyage, except when he cooks his meals. One year, of the twelve
who started from Sarawak on the pilgrimage, but five returned,
though now it is not so fatal, as our authorities in the east are
preventing the over-crowding of those vessels which leave our ports.
They have a custom in Sarawak which is rather curious: to insure
good hair to their girls, they throw gold dust on it, and then send the
child out among the crowd, who with scissors endeavour to snip out
the precious metal.
It has often been noticed that the Malay language is very concise,
and as a proof, I have heard the following anecdote related. I have
not yet seen it in print, though it may be. An English judge was
condemning a man to death for a barbarous murder, and earnestly
dwelling on the dreadful nature of the crime, he lengthened his
discourse to twenty minutes. Then turning to the court interpreter he
told him to translate what he had said into Malay. The official looked
sternly at the prisoner, and addressed him thus: “The judge says you
are a very wicked man; you have committed a great crime, therefore
you must be hung. Sudah (I have done),” and then quietly retired to
his place, to the astonishment of the judge, who could not
comprehend how his learned and affecting discourse had been so
briefly translated; he could only ejaculate, “Certainly the Malay is the
most epigrammatic language.”
As I am concluding this chapter with miscellaneous remarks, I will
tell a short anecdote told me by a Spaniard of a Balignini pirate. After
the expedition from Manilla, in 1848, had captured the islands of
Tonquil and Balignini, they removed most of the prisoners to an
island to the north; among others, there was the wife and children of
a well known buccaneer, who had been absent on a cruise during
the attack, and returning home, found his house burnt and his family
gone. He immediately went to Samboañgan and surrendered to the
authorities, saying he was tired of the wandering life he had led, and
was anxious to live as a quiet agriculturist with his wife. The
governor trusting his story, sent him to the north, where he joined his
family, and set to work with great energy cultivating the soil; the
authorities kept a strict watch over him, knowing his enterprising
character, but just before the rice harvest was ready to be gathered,
they became less vigilant, as they thought no one would abandon
the result of a year’s labour; but at dead of night, with a few
companions to whom he had imparted his secret, he fled with his
family to the shore, where, surprising a boat, he pulled off to his old
haunts and reached them in safety.
I have already treated of the Land and Sea Dayaks, and will not
dwell further on the subject, but give a short account of the Chinese
on the North-west coast of Borneo.
 CHAPTER XII.
THE CHINESE IN BORNEO.

Intercourse between China and the Northern Part of Borneo—

References to the Chinese—Names of Places and Rivers—Sites
of Gardens and Houses—One of the original Settlers—The
Sultan’s Recollections—Chinese numerous in his Youth—
Reasons for their Disappearing—Anecdote of a Murut Chief—
Aborigines speaking Chinese—Mixed Breed—Good Husbands—
Chinese at Batang Parak—At Madihit—Pepper Planters—Origin
of the Borneans—Chinese Features observed also among the
Aborigines—Careful Agriculture—A remnant of Chinese Teaching
—Traditions of a Chinese Kingdom—Effect of Treaty with Brunei
—Unsuccessful attempt to revive Pepper Planting—Chinese
scattering on the North-west Coast—A Spark of Enlightenment—
Attempt to prevent Intercourse between the Chinese and
Aborigines—Decay of Junk Trade—Cochin Chinese—Conduct of
the Chinese—Papar—Anecdote—Fatal Result of Insulting a
Woman—Skirmish—Misrepresented in Labuan—Question of
British Protection to the Chinese—Their Insolence—Anecdote—
Unpleasant Position—A Check—Difficulty of obtaining
Information—Cause of former Disputes—Insurrection of the
Chinese of Brunei—Sarawak—Early efforts of the Chinese to
establish themselves there—Lawless Malays—A Murder—
Retaliation—Defeat of the Chinese—Arrival of Sir James Brooke
—Mixed Breed in Sambas—Form Self-governing Communities—
Defeat of the Dutch Forces—Subjugation of the Chinese—The
Pamangkat Agriculturists—Flight into Sarawak—Change in the
appearance of the Country—Mission School—Visit the Interior—
Kunsis, or Gold Companies—Appearance of the Country—
Method of Gold-working—The Reservoir—The Ditch—The Sluice
—Wasteful method of working—Abundance of Gold—Impetus—
Failure of first Agricultural Schemes—A great Flood—
Troublesome Gold-workers—Successful Scheme—Disturbance
in Sambas—Flight of Chinese—Illiberal Regulation—Tour through
the Chinese Settlements—Agriculture—Siniawan—Chinese
workings—Hot Spring—Gold at Piat in Quartz—Antimony Works
—Extensive Reservoirs—Arrival of Chinese from Sambas—
Denial by the Kunsi—Hard Work at the Gold Diggings—Scenery
 —Path to Sambas—Chinese Station—Numbers of the Chinese
before the Insurrection.
The first thing that strikes an inquirer into the intercourse which
was formerly carried on between China and the northern part of
Borneo, is the prevalence of names referring to these strangers.
They are called in Malay, Orang China; by the Land Dayaks of
Sarawak, Orang Sina; and by the Borneans, Orang Kina, men of
China; and north of the capital, we find Kina Benua, the Chinese
land, in Labuan; Kina Balu, the Chinese widow, the name of the
great mountain; Kina Batañgan, the Chinese river, on the north-east
coast; and we have Kina Taki, the name of a stream at the foot of
Kina Balu and Kina Bañgun, a name of a small river of the north
north eastern coast. Around Brunei we continually come across
terraces cut on the sides of the hills, where the pepper-plant was
grown, particularly on the eminence below the Consulate: and the
places where the Chinese had levelled the ground on which to build
their houses are often to be met with; one of the most distinct was in
my own garden. Their graves are also numerous, and may easily be
traced on the slopes of the hills, though time has worn down their
edges, and left but a slightly swelling mound.
My object is not to write a history of the Chinese intercourse with
Borneo, but to notice what impress it has left on the manners and
thoughts of the people, and what remembrances of them may still be
gathered. At present there are scarcely any of the original settlers
left. I only remember one very old man, who cultivated a garden a
few miles above the town; and although he had lived there for sixty
years, arriving as a child, he had not mastered the language of the
country, and could only say that in old days the Chinese were
numerous.
The reigning sultan used often to converse on the subject, and
told me that his own father was the nobleman appointed to
superintend the Chinese; and that about fifty years ago they were
very numerous to the westward of the town, and that when he was a
youth, he was fond of strolling in their pepper and vegetable
gardens. He did not know “how many there were, but there were
many.” He accounted for their almost total disappearance by saying
that for the last sixty or seventy years they had received no recruits
from China, and that the Chinese gardeners near the town seldom
had wives, but those up the country and in the neighbouring districts
lived among the Murut and Bisaya tribes, and that their descendants
had mixed with the native population and adopted their dress and
habits.
An occurrence which took place whilst I was in Brunei tended to
confirm this. A Chinese pedlar, married to a Murut girl, came to me
one day to complain of the conduct of a Bornean nobleman who had
been oppressing the aborigines. I sent him with the Malay writer
attached to the Consulate to explain his case to the sultan, as I could
not interfere myself.
The following week the chief of the Murut tribe arrived to support
the complaint, and went with the pedlar into the shop of the principal
Chinese trader in Brunei, baba Masu, who began questioning him in
Malay. The man answered in a stupid manner, as if he scarcely
understood him, upon which the baba turned to the pedlar and said
in Hokien Chinese, “What is the use of your bringing such a fool to
support your case?” The chief’s face brightened directly, and he
observed, in good Chinese, “I am not such a fool, but I don’t
understand Malay well.” The trader, very much surprised to be thus
addressed in his own language by a Murut, made particular inquiries,
and found that this was the grandson of an immigrant from Amoy,
who had settled among the aborigines, and had taught his children
his own language, and his eldest son marrying the daughter of an
orang kaya, their son had succeeded to the chieftainship of the tribe.
Subsequently, I questioned some of the Chinese pedlars who
were accustomed to trade in the districts on the coast to the north of
the capital, which are known by the general name of Saba, and they
found there were many of the Bisayas and Muruts of Kalias, Padas,
Membakut, and Patatan, who could speak Chinese very fairly, and
who acknowledged their mixed descent from the Chinese and the
aborigines. Wherever the former settle, they always seek wives
among the people, though few comparatively have the good fortune
to procure them. However, when they do, the women soon become
reconciled to them as husbands, and find a manifest improvement in
their condition, as the Chinese do not like to see their wives do more
than the real domestic work of the house, performing all the more
laborious duties themselves, even to cooking the dinner.
My friend, the orang kaya of the village of Blimbing, on the
Limbang, said he remembered the Chinese living at a place called
Batang Parak, about eighty miles from the mouth of the river. He
himself could only call to mind seven who were cultivating pepper-
plantations in his time, but his father had told him that before the
insurrection the whole country was covered with their gardens. Of
this insurrection, I could obtain few particulars, though they pointed
out a hill at the mouth of the Madalam where the Chinese had built a
fort, but had been defeated by the Bornean forces.
A hundred and fifty miles up the Limbang, on the banks of the
Madihit branch, and beyond all the worst rapids, the Muruts told us
the Chinese formerly had very extensive pepper-plantations; but
within the remembrance of their oldest men, they had all died away,
no new recruits joining them, and their descendants were lost among
the surrounding tribes.
There is but one objection to the theory that the Borneans derive
their origin in great part from the former Chinese settlers: it is that
they are even darker than the other Malays; otherwise, the
squareness and heaviness of feature, particularly observable among
the lower classes, would seem to mark them as descendants of the
labouring Chinese who form the bulk of the emigrants from China,
though I have often observed that many of the children of the
undoubtedly mixed breed were very dark. I have noticed in my
account of our first expedition to Kina Balu the fact of the young girls
at the village of Ginambur having the front of their heads shaved
after the manner of the Chinese. I do not remember having seen any
female of the other tribes of aborigines disfigured in the same way.
When we were at the village of Kiau, at the base of Kina Balu, we
continually remarked faces which showed distinct indications of
being descended from the celestials.
I have before noticed the superior style in which the natives to the
north of Brunei carry on their agricultural operations. I find my
description of the method pursued by the Bisayas of Tanah Merah in
cultivating pepper exactly agrees with that of the Chinese mentioned
by Forrest in his account of Borneo Proper. And the natives of
Tawaran and Tampasuk cultivate their rice as carefully as the
Chinese, following their example of dividing the fields by low
embankments, so as to be able to regulate the supply of water; and
in no other part of Borneo are to be found gardens as neat as those
we saw on the plain of Tawaran. It is evident they have not yet
forgotten the lessons taught to their forefathers by the Chinese,
though their improved agriculture appears to be almost the only
impress left on the people. Instead of their following the more
civilized race, the latter appear to have completely blended with and
become lost among the numerous population around.
The tradition is still well known among the natives, of the whole
country being filled with those immigrants; and they say that in very
ancient days there was an empire ruled by one of the strangers, and
the Sulus have still the tradition current among them that in former
days these islands formed a part of a great Chinese kingdom, whose
seat of government was in the north of Borneo. Forrest having
mentioned that the Sulus in his day had such a tradition, drew my
attention to it, and it may refer to the time subsequent to the invasion
of the country by Kublai Khan’s general. The following is an extract
from the genealogy of the sovereigns of Borneo, which is in the
possession of the pañgeran tumanggong:—“He who first reigned in
Brunei, and introduced the religion of Islam, was his Highness the
Sultan Mahomed, and his Highness had one female child by his wife
the sister of the Chinese rajah, whom he brought from Kina
Batañgan (Chinese river), and this princess was married to Sherif
Ali, who came from the country of Taib, and who afterwards
governed under the name of his Highness Sultan Barkat (the
Blessed), and it was he who erected the mosque, and whose
Chinese subjects built the Kota Batu, or stone fort.” This appears to
refer to some kind of a Chinese kingdom.
In 1846 there was scarcely a Chinese left in the capital; but no
sooner was our treaty made in 1847, than traders from Singapore
began to open shops there. At first, it appeared as if a valuable