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THE FVA-DVA Puzzle: Completing Markets with Collateral Trading Strategies

by Claudio Albanese of Global Valuation Ltd., and
Stefano Iabichino of Global Valuation Ltd.

April 24, 2013

Abstract: The market practice for valuation of fixed income derivatives has significantly diverged from the principles of arbitrage-free pricing.

Discrepancies arise because of the incompleteness of collateral trading markets which lack of reverse REPO contracts for cash upgrades accepting OTC derivatives as general collateral. This circumstance forces banks to implement sub-optimal super-replication strategies generating spurious payoffs that occur only after the default of the bank itself. The costs that banks sustain prior to default are quantified as the FVA and DVA.

In this paper, we outline collateral trading strategies that resolve the incompleteness and render both the FVA and the DVA equal to zero and restore the validity of classical risk neutral pricing based on OIS discounting, thus optimizing the efficiency of financial intermediation services.

JEL Classification: D53, G13.

Keywords: FVA, DVA, counterparty credit risk, margin lending.

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