Quantitative Finance Stack Exchange is a question and answer site for finance professionals and academics. It only takes a minute to sign up.
Sign up to join this community
I've read multiple references that imply that the valuation of OTC derivatives being related to bank funding cost. Given that an uncollateralised OTC derivative needs no funding from the bank's treasury - no cash is required to maintain the position - I am struggling to see the connection.
Is there a simple relation between the two that I've missed? Is there a relationship between the value of the derivative and what the bank posts onto their balance sheet?
Here are two scenarios where physical cash is immediately required from the treasury to fund the position;
A bank will typically hedge its exposure using the interbank market which have collateralised trades. If the uncollateralised trade moves positively and becomes an asset the hedge, natyrally, moves adversely and becomes a liability. The bank will be required to post collateral on the liability and it will receive nothing fron the uncollateralised trade, meaning a cash injection.
On a collateralised trade when a coupon payment is made the NPV of the remaining trade is adjusted and the side with liability who receives the coupon posts it back to the asset holder as collateral, so although there is a transfer of ownership of cash there is no practical movement of cash. Not so with uncollateralised trades. The coupon payment is a physical movement of cash and needs to be funded if it is an outflow.
edit..
Capital charges for banks, as specified by Basel III, form a different kind of funding charge. The minimum capital that a bank is required to hold against the trade, in terms of risk capital charge, leverage ratio, and/or risk-weighted-asset (RWA) charge are more stringent in general for uncollateralised trades. Bank capital costs are measured against the cost of funding.
