Regulators clearly believe that derivativescan never be risk free. Regulators have risk preferences and by imposing costly actions on banks they have made derivatives markets incomplete. These actions have idiosyncratic effects, for example the stress period for Market Risk capital is determined at the bank level, not at desk level. Idiosyncratic effects mean that no single measure makes assets and derivatives martingales for all market participants. Hence the market has no risk-neutral measure and Regulatory-compliant derivatives pricing is not risk-neutral. Market participants have idiosyncratic, multiple, risk-neutral measures but the market does not. Practically, we show that derivatives desks leak PnL (profit-and-loss) even with idealized markets providing credit protection contracts and unlimited liquidity facilities (i.e. repos with zero haircuts). This PnL leak means that derivatives desks are inherently risky as they must rely on competitive advantages to price in the costs of their risks. This strictly positive risk level means that Regulatory-required capital must also have strictly positive costs. Hence Regulatory-compliant derivatives markets are incomplete. If we relax our assumptions by permitting haircuts on repos the situation is qualitatively worse because new Regulatory-driven costs (liquidity buffers) enter the picture. These additional funding costs must be met by desks further stressing their business models. One consequence of Regulatory-driven incomplete-market pricing is that the FVA debate is resolved in favor of both sides: academics on principles (pay for risk); and practitioners on practicalities (desks do pay). As a second consequence we identify appropriate exit prices .
Regulations impose idiosyncratic capital and funding costs for holding derivatives. Capital requirements are costly because derivatives desks are risky businesses; funding is costly in part because regulations increase the minimum funding tenor. Idiosyncratic costs mean no single measure makes derivatives martingales for all market participants. Hence Regulatory-compliant pricing is not risk-neutral. This has implications for exit prices and mark-to-market .
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Regulators clearly believe that derivativescan never be risk free. Regulators have risk preferences and by imposing costly actions on banks they have made derivatives markets incomplete. These actions have idiosyncratic effects, for example the stress period for Market Risk capital is determined at the bank level, not at desk level. Idiosyncratic effects mean that
Regulations impose idiosyncratic capital and funding costs for holding derivatives. Capital requirements are costly because derivatives desks are risky businesses; funding is costly in part because regulations increase the minimum funding tenor. Idiosyncratic costs mean
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assets and
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the market has no risk-neutral measure and
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derivatives
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Market participants have idiosyncratic, multiple, risk-neutral measures but the market does not. Practically, we show that derivatives desks leak PnL (profit-and-loss) even with idealized markets providing credit protection contracts and unlimited liquidity facilities (i.e. repos with zero haircuts). This PnL leak means that derivatives desks are inherently risky as they must rely on competitive advantages to price in the costs of their risks. This strictly positive risk level means that Regulatory-required capital must also have strictly positive costs. Hence Regulatory-compliant derivatives markets are incomplete. If we relax our assumptions by permitting haircuts on repos the situation is qualitatively worse because new Regulatory-driven costs (liquidity buffers) enter the picture. These additional funding costs must be met by desks further stressing their business models. One consequence of Regulatory-driven incomplete-market pricing is that the FVA debate is resolved in favor of both sides: academics on principles (pay for risk); and practitioners on practicalities (desks do pay). As a second consequence we identify appropriate exit prices
This has implications for exit prices and mark-to-market