Sep 25, 2012

A Primer on Funding Value Adjustment (FVA)

Numerix Video Blog #2: A Primer on Funding Value Adjustment (FVA)

As more and more banks believe that funding is becoming as important as credit risk in derivatives valuation the industry debate has evolved past the well understood concepts of counterparty credit quality (Credit Value Adjustment – CVA) and a firm’s own creditworthiness (Debt Value Adjustment – DVA ) – to concerns over funding the rising, and sometimes unpredictable cost of collateral.

In this video blog, we will delve into this issue with Numerix Host James Jockle, SVP of Marketing, and Denny Yu, Product Manager Risk of Client Solutions, discussing the debate over FVA, including proposed methodologies, the notion of collateralized versus uncollateralized trades and OIS valuation challenges in the presence of CSA thresholds. What do you think? What is your take on the evolving FVA Debate?

Weigh in and continue the conversation on Twitter @nxanalytics, LinkedIn, or in the comments section below.

Blog Transcript: “A Primer on Funding Value Adjustment”

Jockle (Host): Hi welcome to the Numerix video blog I’m your host Jim Jockle, and with me today is Denny Yu, from our Numerix client solutions group. Thank you Denny for joining us.

Yu (Guest): Thank you for having me.

Jockle: So let’s talk about FVA, over the past year Basel III introductions, CVA charges essentially bringing the management of credit risk into market risk sensitive type instruments, and it’s been hotly debated so we’ve had DVA, CVA now the issue is FVA – Funding Value Adjustments. Let’s start with a definition because I don’t think there’s consensus on one.

Yu: So let’s just take a quick step back to the origins of FVA, so after the financial crisis regulation has been put in place for CVA and the DVA calculation so that’s become pretty clear and that’s to incorporate the counterparty credit risk into the transaction into the OTC derivative transaction now post crisis we’ve seen the market move away from funding at the LIBOR rate into using a rate typically that’s higher than LIBOR, so for collateralized transactions funding typically is done using the overnight rate – Fed fund futures for the US for collateralized securities and its clear now that the market has moved to valuing these derivatives using a OIS benchmarked rate.

From the unsecuritized derivatives perspective what we’ve seen is a large dispute in terms of correct valuation. So Funding Value Adjustment in summary really means that now traders have to own the cost of funding of that derivative transaction whether its funding for the swap transaction, funding for the premium on the option as well as the appropriate discount rate for discounting future cash flows. So now that has to be incorporated into the desk of the traders P&L where before it typically was not a concern because things were funded at LIBOR.

Jockle: So now you mentioned something in terms of collateralized versus uncollateralized and clearly that’s been a lot of debate lately around uncollateralized trades why don’t you give some insight between what’s going on there.

Yu: Right, so if we look at what a collateralized trade is typically that’s a CSA agreement between the two counterparties and in most states now we’ve seen a daily collateral call frequency which means on a daily basis the counterparties market their positions and if one side had positive exposure that side can call for additional collateral to make the credit derivative or the collateralized derivative whole. What that means is that we now can receive and post collateral on a daily basis. One way I’ve heard of calculating the FVA on collateralized transactions is to think of the CSA today that has parameters such as  minimum transfer amounts, collateral thresholds, rounding, other parameters that introduce friction into the CSA means that that the full collateral that really needs to be collected to immunize that credit exposure is not collected. Contrast that with what we’d call a perfect CSA where there are no thresholds as soon as you call for collateral you get it instantaneously and if you calculate the difference between how much collateral you would have collected in a perfect CSA versus today’s current CSA and take that difference multiply it by the funding spread that would be considered your Funding Value Adjustment for collateralized securities.

Jockle: So what you’re saying here is, in absence of a perfect CSA or absence of a CSA all together that’s considerable valuation challenges in terms of what the mark is between counterparties – is that correct?

Yu: That is correct. So that biggest challenge right now is finding the appropriate funding spread. So one way we can thing about a Funding Value Adjustment is the sum between a funding charge adjustment and a funding benefit adjustment. And a funding charge adjustment is really that trading desk typically has to finance from the the financing desk of the bank at some charge and typically this is some spread that the bank pays the marketplace. So that’s straightforward to calculate. The funding benefit really is for exposure that is uncollateralized whether it’s because of an imperfect CSA or because it’s uncollateralized derivatives in general the bank essentially enjoys a benefit by not having to finance that collateral. And so there’s the debate on the correct funding spread to be used there is it the financing spread of the bank is it an aggregate spread of the bank and in general from a funding spread perspective there’s a lot of dispute on the correct or appropriate spread to use whether it’s the funding spread of the bank taken from the bond markets of that bank’s bonds or the CDS rate of that bank or even the basis between the cash synthetic or the basis between the bond spreads and the CDS spreads.

Jockle: So now what’s the implication the buy-side participant or the corporate participant outside of the bank to bank relationships?

Yu: What we’ve seen here largely when we speak to our clients and speak to industry market participants is that because the valuation differences – when a bank includes there FVA into the economic value and essentially quote this to corporates or other inter-broker dealers what you’ll see is that this can be vastly different from the  market-to-market value that the corporate calculates which is usually a risk neutral price that may or may not include that corporates funding cost or even between banks if one bank has a funding spread of LIBOR plus 50 and another has LIBOR plus 150 there’re going to come to the table with vastly different valuations and then that you can see how this in the industry can cause a lot of disputes in terms of just marking to market.

Jockle: So final question and we’ll wrap up because I think we’re going to be talking about this for a while. So next steps in the market, clearly we’ve got to get on the same page clearly there’s a lot of potential for discrepancies what do you see as the interim next steps?

Yu: So just like we’ve seen regulation come down the pipeline and legislation come down for the CVA calculation both on the financial accounting side as well as on the regulatory capital side we’d expect either regulation to figure out how much the FVA calculation should factor into both on an accounting standard as well as a regulatory standard. We’re either looking for something coming down from regulation or looking from industry consensus from the banks themselves either organizing and coming to a mainstream consensus as to what the calculation should be. If you go online today you can find multiple papers on different ways of calculating FVA and so there’s a wide disparity in opinions on how to calculate that. Major bank broker dealers today are calculating a certain way, second-tier, third tier institutions are typically price takers in that sense so until the playing field is leveled with regulation or legislation or industry consensus we’re going to continue to see these valuation disputes.

Jockle: Thank you Denny. So this is going to be a continuing topic of conversation on the Numerix video blog and I would encourage you to join the debate tweet us @nxanalytics and as news and events are breaking in the market we’ll be sure to be covering them.

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