We propose a risk-sharing framework for bilateral contracts to find the optimal pair, initial price and amount of collateral, with presence of default risks, collateral, and funding spreads. The derived optimal collateral can be used for contracts between financial firms and non-financial firms. For inter-dealers contracts, which are governed by regulations, the optimal collateral can interpret circumstances where the margin requirement is indeed optimal. We will see later that absence of market frictions is an inherent assumption for the margin requirement in Basel III. In addition, as we consider entity-specific information in bilateral pricing , law of one price does not hold. Moreover, inclusion of funding spreads causes asymmetry in individual pricing. Thus, the two parties should enter  derivative contracts with a negotiated price, which is the other part of the solution of the risk-sharing framework. The risk-sharing framework defines the negotiation as a problem that maximizes the sum of utilities of the two parties. The optimal pricefrom the risk-sharing framework does not have asymmetry due to different funding spreads of each party .
We introduce a two-agent problem which is inspired by price asymmetry arising from funding difference. When two parties have different funding rates, the two parties deduce different fair prices for derivative contracts even under the same pricing methodology and parameters. Thus, the two parties should enter the derivative contracts with a negotiated price, and we call the negotiation a risk-sharing problem. This framework defines the negotiation as a problem that maximizes the sum of utilities of the two parties. By the derived optimal price, we provide a theoretical analysis on how the price is determined between the two parties. As well as the price, the risk-sharing framework produces an optimal amount of collateral. The derived optimal collateral can be used for contracts between financial firms and non-financial firms. However, inter-dealers markets are governed by regulations. As recommended in Basel III, it is a convention in inter-dealer contracts to pledge the full amount of a close-out price as collateral. In this case, using the optimal collateral, we interpret conditions for the full margin requirement to be indeed optimal .
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propose a risk-sharing framework for bilateral contracts to find the optimal pair, initial price and amount of collateral, with presence of default risks, collateral, and funding spreads. The derived optimal collateral can be used for contracts between financial firms and non-financial firms. For inter-dealers contracts, which are governed by regulations, the optimal collateral can interpret circumstances where the margin requirement is indeed optimal. We will see later that absence of market frictions is an inherent assumption for
introduce a two-agent problem which is inspired by price asymmetry arising from funding difference. When two parties have different funding rates,
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margin requirement in Basel III. In addition, as we consider entity-specific information in bilateral pricing , law of one price does not hold. Moreover, inclusion of funding spreads causes asymmetry in individual pricing.
two parties deduce different fair prices for derivative contracts even under the same pricing methodology and parameters.
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the
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which is the other part of the solution of the
and we call the negotiation a
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framework. The risk-sharing
problem. This
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The optimal pricefrom the
By the derived optimal price, we provide a theoretical analysis on how the price is determined between the two parties. As well as the price, the
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does not have asymmetry due to different funding spreads of each party
produces an optimal amount of collateral. The derived optimal collateral can be used for contracts between financial firms and non-financial firms. However, inter-dealers markets are governed by regulations. As recommended in Basel III, it is a convention in inter-dealer contracts to pledge the full amount of a close-out price as collateral. In this case, using the optimal collateral, we interpret conditions for the full margin requirement to be indeed optimal