Valuation and Hedging of OTC Contracts with Funding Costs, Collateralization and Counterparty Credit Risk: Part 1

by Tomasz Bielecki of Illinois Institute of Technology, and
Marek Rutkowski of University of Sydney

June 21, 2013

Abstract: The research presented in this work is motivated by recent papers by Brigo et al. [9, 10, 11], Crépey [12, 13], Burgard and Kjaer [3], Fujii and Takahashi [16], Piterbarg [29] and Pallavicini et al. [28]. Our goal is to provide a sound theoretical underpinning for some results presented in these papers by developing a unified martingale framework for the non-linear approach to hedging and pricing of OTC nancial contracts. The impact that various funding bases and margin covenants exert on the values and hedging strategies for OTC contracts is examined. The relationships between our research and papers by other authors, with an exception of Piterbarg [29] and Pallavicini et al. [28], are not discussed in this Part 1 of our research. More detailed studies of these relationships and modeling issues are examined in the follow-up Part 2.

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