Collateral Convexity of Libor and FX Forwards (Slides)

Collateral discounting recognises the value of funding for derivatives, which has gained prominence in recent years as basis spreads have widened in response to the financial crises. This article considers the impact of collateral volatility on discount factors and Libor and FX forwards, and re-examines the core assumptions of the approach. Convenient expressions are derived for convexity adjustments and collateral options, in a form that easily integrates into curve building and pricing. Analysis of the models with reasonable volatility assumptions suggests that these pricing adjustments are not negligible.