I'm trying to improve my understanding of valuation under collateralisation.
One point that is made within multiple sources is for an uncollateralised derivative, how a future cashflow is equivalent to a loan made to that counterparty, and how the holder of the derivative must take that loan.
I just can't see this equivalence. If we were to 'convert' or 'realise' a future cashflow to a present cashflow (to, for example, pay salaries or some other cost), then we would have to go out and borrow some amount, with the repayment of that principle plus interest to be made by that future cashflow (the basic present value arbitrage reasoning). So we discount the future value by whatever the cost of funding is. Nowhere is there a relationship with the derivative counterparty. Further, I can't see how there is a mandatory requirement to take this loan.
Is there a simple perspective that I have missed that would resolve my confusion?
Assume the swap is not collateralized, then you have to fund all future values. The net payments in the swap are then payed by corresponding the maturing of the corresponding funding contracts (which you created dynamically in your hedge).
(why do we have to fund anything?)
Let us consider the situation where the firm A has a positive present value (PV) in the contract with the firm B with high credit quality. From the view point of the firm A, it is equivalent to providing a loan to the counterparty B with the principal equal to its PV. Since the firm A has to wait for the payment from the firm B until the maturity of the contract, it is clear that A has to finance its loan and hence the funding cost should be reflected in the pricing of the contract. (again, why does firm A has to finance anything)
they are effectively unsecured borrowing and lending with the counterparty
Similarly, a funding cost arises for the bank when a derivative has a positive market value. The purchase of an ‘in the money’ or asset position derivative requires the bank to pay cash. The incremental cost of funding this purchase can also be seen as equivalent to the cost of the bank raising funding.
I can understand why a bank would need to fund if they were to purchase an in the money derivative, but why does there need to be any funding for a derivative that starts with zero valuation and then goes into the money?