Jun 5, 2015

The Introduction of Margin Valuation Adjustment: A Newcomer to the ‘XVA Party’

As the XVA valuation framework continues to evolve, today’s derivative practitioners are facing a new slew of complicated computational and other challenges as they work hard to achieve their end goal—profitability. With ever-increasing regulations being implemented and rolled-out, what should we be looking at when it comes down to best practices in dealing with the growing list of XVA pricing adjustments?

From DVA to FVA and even KVA, just when we thought we had it all figured out, we recently found ourselves in a discussion regarding the newest valuation adjustment to join the ‘XVA party’—MVA (Margin Variation Adjustment).

The introduction of the March 2015 Basel Committee and International Organization of Securities Commissions’ (IOSCO) revision to the original framework for margin requirements for non-centrally cleared derivatives has the market once again contemplating current practices, while evaluating future preparations and operational processes. Also this March, the Basel Committee and IOSCO agreed to adopt a phase-in arrangement for exchange variations margins. In addition, the revision stated that the beginning of the phase-in period for collecting and posting initial margin on non-centrally cleared trades was moved from December 2015 to September 2016—with the full phase-in schedule being adjusted to reflect the delay, according to the Bank for International Settlements (BIS) —thereby granting OTC derivative market participants a little more time to prepare. 1 

With all of these changes on the imminent horizon, it is no surprise to see market participants fully reacting to the imposition of margin on OTC derivatives, whether initial margin or variation margin—and also introducing the MVA adjustment into the picture.

MVA corresponds to these recent regulations issued for margin rules for OTC derivatives, initial margin and variation margin. Essentially, the standardized approach to this is in its final form and will be in effect September 1st of next year. MVA is a pretty new concept, but by analogy with all of the other valuation adjustments—if you have a computation of margin, the effect of that computation should be included into your price, just like for the other valuation adjustments. The concept of MVA, though a relative newcomer into the valuation adjustment picture, naturally fits into the XVA valuation framework. The bottom-line: if we are going to account for initial margin, we should also account for MVA.

Moreover, creating a trade profitability framework and bringing all of the XVAs into trading decisions will enable better decision making amongst financial institutions. We all know by now that a trade that is profitable at first glance can turn out to be a loss-making trade when all costs are incorporated.

At the end of the day, “XVA and risk are two sides of the same coin. The end goal is of course ‘risk informed’ pricing for trading decisions and mark-to-market,” says Numerix Chief Strategy Officer, Satyam Kancharla.

For a visual analysis and breakdown of the valuation adjustments, read the Numerix advisory infographic, “XVAs Defined: The Profitability Puzzle.”  

1Revisions to implementation of margin requirements for non-centrally cleared derivatives issued by the Basel Committee on Banking Supervision (BCBS) and IOSCO – press release, 18 March 2015, www.bis.org/press/p150318a.htm

 

 

 

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