– The purpose of this paper is to provide a framework of replication pricing of derivatives and identify funding valuation adjustment (FVA) and credit valuation adjustments (CVA) as price components.
– The authors propose the notion of bilateral replication pricing. In the absence of funding cost, it reduces to unilateral replication pricing. The absence of funding costs, it introduces bid–ask spreads.
– The valuation of CVA can be separated from that of FVA, so-called split up. There may be interdependence between FVA and the derivatives value, which then requires a recursive procedure for their numerical solution.
– The authors have assume deterministic interest rates, constant CDS rates and loss rates for the CDS. The authors have also not dealt with re-hypothecation risks.
– The results of this paper allow user to identify CVA and FVA, and mark to market their derivatives trades according to the recent market standards.
– For the first time, a line between the risk-neutral pricing measure and the funding risk premiums is drawn. Also, the notion of bilateral replication pricing extends the unilateral replication pricing.
