Regulatory-Compliant Derivatives Pricing Is Not Risk-Neutral

Abstract

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.

Keywords: Risk-neutral pricing, Regulators, regulations, FVA, CVA, capital, incomplete markets

JEL Classification: D40, D52, D81, E61, G12, G13, G14, G15, G18, G21, G28, K23, L51, M41, M20