Negotiating Derivative Prices and Collateral Through Risk Sharing

Summary

The document presents a two-party framework for negotiating derivative contracts when counterparties face different funding rates. Because funding differences can lead them to calculate different fair prices using the same pricing approach and assumptions, the parties need an agreed contract price. The framework defines negotiation as maximizing the combined utilities of both parties and derives an optimal price from that objective.

It also derives an optimal collateral amount and discusses its possible use in contracts between financial and non-financial firms. For inter-dealer contracts, where regulations and Basel III conventions call for collateral equal to the close-out amount, the analysis describes conditions under which that full margin requirement is optimal. The source gives a theoretical account but no empirical evidence, calibration details, or implementation results. Its conclusions depend on the model’s assumptions about the parties’ funding, utility, and contract risks, which are not specified in the provided text.

Key ideas

• Different funding rates can cause counterparties to assign different fair prices to the same derivative.
• The framework chooses a negotiated price to maximize the parties’ combined utility.
• The analysis derives an optimal amount of collateral alongside the contract price.
• The framework considers contracts between financial firms and non-financial firms.
• It identifies conditions under which full close-out-price collateral is optimal for inter-dealer contracts.

Tags

# A Risk-Sharing Framework of Bilateral Contracts


# A Risk-Sharing Framework of Bilateral Contracts









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.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.