Regulatory-Compliant Derivatives Pricing Is Not Risk-Neutral

Abstract

Regulations impose idiosyncratic capital and funding costs for holding derivatives. Capital requirements are costly because derivatives desks are risky businesses; funding is costly in part because regulations increase the minimum funding tenor. Idiosyncratic costs mean no single measure makes derivatives martingales for all market participants. Hence Regulatory-compliant pricing is not risk-neutral. This has implications for exit prices and mark-to-market.

Arbitrage-free pricing of derivatives in nonlinear market models

“…Last but not least, it should be acknowledged that the valuation of derivatives based on arbitrage-free replication (or superhedging) should not be seen as the most realistic pricing approach, but rather a mathematical idealization of a much more complex situation, and thus other pricing paradigms should also be examined. The interested reader is referred to Kenyon and Green (2013) for a discussion of a regulatory-compliant derivatives pricing and to for a novel balance-sheet approach to XVA with the special emphasis on KVA (capital value adjustment) computations.…”

Arbitrage-Free Pricing Of Derivatives In Nonlinear Market Models

“…Last but not least, it should be acknowledged that the valuation of derivatives based on arbitrage-free replication (or superhedging) should not be seen as the most realistic pricing approach, but rather a mathematical idealization of a much more complex situation, and thus other pricing paradigms should also be examined. The interested reader is referred to Kenyon and Green [35] for a discussion of a regulatory-compliant derivatives pricing and to Albanese and Crépey [2] for a novel balance-sheet approach to XVA with the special emphasis on KVA (capital value adjustment) computations.…”