Risky Funding: A unified framework for counterparty and liquidity charges

by Massimo Morini of Banca IMI, and
Andrea Prampolini of Banca IMI

August 30, 2010

Abstract: Standard techniques for incorporating liquidity costs into the fair value of derivatives produce counter-intuitive results when credit risk of the counterparty (CVA) and of the investor (DVA) are added to the picture. Here, Massimo Morini and Andrea Prampolini show that a consistent framework can only be achieved by giving an explicit representation to the funding strategy, including associated default risks.

JEL Classification: G13.

Keywords: counterparty risk, CVA, DVA, funding, liquidity, bond-CDS basis.

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