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Derivatives Discounting Explained

Derivative pricing is about cash flow discounting at the riskfree rate. This teaching has lost its meaning post the financial crisis, due to the addition of extra value adjustments (XVA), which also made derivatives pricing and valuation a very difficult task for investors. This article recovers a properly defined discount rate that corresponds to different collateral and margin schemes. A binomial tree model is developed, enabling end-users to price in counterparty default and funding risk. Coherent XVAs, if needed, naturally result from decomposing the discount rate, and can be computed on the same tree.