The fundamental representation of pricing adjustments

Abstract

This article consolidates and extends past work on derivative pricing adjustments, including XVA, by providing an encapsulating representation of the adjustment between any two derivative pricing functions, within an Ito SDE/parabolic PDE framework. We give examples of this representation encapsulating others from the past 20 years, ranging from a well known option pricing adjustment introduced by Gatheral, to the collection of semi-replication XVA originating from Burgard & Kjaer. We show that this fundamental representation can be applied to quantify and mitigate XVA model risk, providing a novel approach to estimating CVA wrong-way risk as an example application.

21 pages, 3 figures