An initial approach to Risk Management of Funding Costs

Abstract: In this note we sketch an initial tentative approach to funding costs analysis and management for contracts with bilateral counterparty risk in a simplified setting. We depart from the existing literature by analyzing the issue of funding costs and benefits under the assumption that the associated risks cannot be hedged properly. We also model the treasury funding spread by means of a stochastic Weighted Cost of Funding Spread (WCFS) which helps describing more realistic financing policies of a financial institution. We elaborate on some limitations in replication-based Funding / Credit Valuation Adjustments we worked on ourselves in the past, namely CVA, DVA, FVA and related quantities as generally discussed in the industry. We advocate as a different possibility, when replication is not possible, the analysis of the funding profit and loss distribution and explain how long term funding spreads, wrong way risk and systemic risk are generally overlooked in most of the current literature on risk measurement of funding costs. As a matter of initial illustration, we discuss in detail the funding management of interest rate swaps with bilateral counterparty risk in the simplified setup of our framework through numerical examples and via a few simplified assumptions.