The links between credit risk and funding cost
In this chapter we clarify the connections between funding costs and adjustments due to the compensation that a party has to pay to the counterparty for losses on a contract caused by its default (so-called debit value adjustment, hereafter DVA). We offer a robust conceptual framework so that DVA can be consistently included in the balance sheet of a financial institution.1
Under the perspective we present below, DVA does not manifest any counterintuitive effects, such as reduction of the current value of the liabilities of a counterparty when its creditworthiness worsens. Moreover, identifying the link between funding costs and DVA, and the contribution of the credit risk the bank bears (so-called credit value adjustment, CVA) allows us to establish a method to discount positive and negative future cash flows thoroughly. The results are quite convenient since, after taking everything into account, things surprisingly and dramatically simplify, at least from a pricing and valuation point of view.
10.2 THE AXIOM
To derive a consistent theory of the links between funding and liquidity costs and counterparty and credit risks, we need to devise an axiom that will be both sensible and widely accepted.
Axiom 10.2.1. As in every human economic activity (by the very definition of the adjective “economic”), the stockholders of a bank aim at making profits out of their investments in business activity. As such they evaluate ...