Abstract
Traditionally, derivatives pricing theory assumed that market participants can “borrow at the risk free rate” whenever necessary to replicate payoffs or carry out arbitrages. However, this is a poor assumption in current market conditions. We explore what impact relaxing this assumption has on derivatives pricing theory and practice and show why understanding this is crucial for managing and pricing the funding commitments embedded in uncollateralised derivative transactions. We split uncollateralised derivatives into two categories, loosely analogous to liabilities and assets. For the first we show that there is still a single arbitrage free price, and explain why computing this price can be difficult in practice. For the second category, we show that there is a wide range of prices consistent with a lack of arbitrage, even for simple payoffs, and we discuss whether equilibrium arguments or tools from corporate finance can shed any light on what the price of these instruments should be.
[PDF] Slides of the presentation.