Funded vs Un-Funded

[WhizzKidd]

Hi @David Harper CFA FRM,

What is the concept of "funding cost" being mentioned in the chapter?

What is the difference between a funded derivative vs. an un-funded one? And what is the funding/liquidity risk related to? I understand it as the ability to obtain a loan and the i-rate one has to pay on that borrowing, or it is the ability to keep up with margining (funding ito the cost of managing the margining requirements on the derivative).

And I am struggling to understand how collateral received when rehypothecated can be used to reduce funding costs. For example, if A transacts with B, B then received from A collateral and posts it on a transaction with C. What is the funding in such a scenario?

 

[David Harper CFA FRM]

Hi @WhizzKidd

To which chapter are you referring, sorry? (it's one of Gregory's obviously....). I think of "funding costs" as the cost of cash or the borrowing cost of cash. This can be explicit or implicit (opportunity cost of cash invested elsewhere). If you purchase a bond, you need to pay for it, or borrow cash to pay for it. Or, if you want to purchase a commodity, you need to fund the purchase with cash, or borrow to pay for it (hence spot market is sometimes called the cash market). Purchased bond or purchased commodity is "funded," but you can gain a similar price exposure with, respectively, writing an (unfunded) CDS or taking a position in a forward contract (so they are unfunded). So i would generalize to say that funding cost apply whenever there is borrowing cost (and cash is just an instance of where you have borrowed from yourself, because it cannot be used elsewhere). Under this definition, unfunded derivative positions do not have borrowing (or financing) cost. I am comfortable with this because I am leaning on Hull's cost of carry where the (r) is the funding cost of commodity ownership. But I'm sure somebody could do better with the definition ...

With respect to collateral, I think the idea is that secured borrowing ought to be cheaper (lower rate) than unsecured borrowing. So, if you are financial institution (FI) and I am the client and we enter into a derivative position with bilateral collateral posting, you probably hedge this with a third-party counterparty. If the position moves in your favor, I post additional collateral and rehypothetication means that--because your hedged position went negative and you need to post collateral--instead of funding (paying for) additional collateral, you re-use mine. In general, re-use of my collateral ought to lower your funding cost to the extent you can do a "secured borrowing" rather than an unsecured borrowing. I hope that's helpful!