Conic cva and dva for option portfolios

Sjoerd Van Bakel, Svetlana Borovkova*, Matteo Michielon

*Corresponding author for this work

Research output: Contribution to JournalArticleAcademicpeer-review

Abstract

In this paper, we propose a framework for credit and debit valuation adjustments (CVA and DVA, respectively) for options and option portfolios which is based on conic finance, that is, where the positions are valued at their bid or ask prices depending on whether they are assets or liabilities. This can be achieved by transforming the pricing measure via appropriate distortion functions, depending on (at least) one parameter. We apply our methodology, which is based on the Wang transform, to portfolios of European commodity futures options, and we show that both CVA and DVA are significantly impacted by bid-ask spreads, when compared to their traditional risk-neutral counterparts. In particular, we show that DVA decreases when computed under conic finance settings, which is in line with the regulatory efforts to rein in DVA gains for financial institutions resulting from their own credit quality deterioration. Finally, we investigate the robustness of our approach with respect to the calibrated parameters, and we show that the calibrated distortion parameter is an excellent explanatory variable for the observed bid-ask spreads.

Original languageEnglish
Article number2050032
JournalInternational Journal of Theoretical and Applied Finance
Volume23
Issue number5
DOIs
Publication statusPublished - 1 Aug 2020

Keywords

  • bid-ask spread
  • Black model
  • commodity option
  • Conic finance
  • CVA
  • distortion function
  • DVA
  • futures option
  • liquidity
  • Wang transform

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