Oct 24, 2012

Understanding FVA: What’s Changed, What’s Next?

When it comes to complex derivative valuation adjustment computations, market practitioners have primarily been focused on Credit Value Adjustment (CVA) and Debit Value Adjustment (DVA) over the past year. This is clearly no surprise given the current regulatory landscape. However, lately, a fairly ‘new’ player has entered the arena and is taking on a kind of center stage of its own: Funding Value Adjustment (FVA).

Yes, it’s been around for awhile (though mainly ignored pre-crisis when the cost of funding was cheap); but, it is no wonder that FVA has come into sharper focus recently with funding costs dramatically on the rise.  Again, it’s a whole new world…

In order to truly understand what’s going on with FVA today, it’s important to take a closer look at the pre-crisis view of funding. During the pre-crisis period of practically unlimited liquidity, banks could expect to borrow money for posting collateral via a variety of low cost funding options. The cost of this borrowing was largely offset by the interest paid on collateral by the receiving party. This allowed banks to disregard collateral funding costs in assessing trading desk profit-and-loss (P&L), explains Dr. Alexander Sokol, a quantitative specialist in this area and Numerix founder, during the recent Numerix webinar, Deciphering FVA.

 What’s Changed?

 Since that time (i.e. ‘post-crisis’), a fundamental shift occurred in the role of funding in the derivatives business. Funding has become costly, making it essential (many believe) to consider the cost of funding in assessing OTC derivatives’ P&L. Liquidity risk makes evaluating and controlling OTC derivatives’ funding needs a critical part of the risk management strategy for many institutions, with the cost of collateralization becoming a significant part of P&L for many OTC transactions, Dr. Sokol adds.

FVA: A Basic Definition

FVA is the difference between portfolio value under the actual collateral agreement, and portfolio value under CSA/OIS discounting which assumes perfect collateral agreement, explains Dr. Sokol. And, in the absence of a collateral agreement, FVA is the difference between portfolio value under unsecured (“LIBOR”) and the value under CSA/OIS discounting. FVA is the precise way to model the impact of collateral terms, in cases other than perfect collateral agreement? or no collateral agreement, he adds.

FVA and Central Counterparties: Current Concerns Explored

During the webinar discussion, Dr. Sokol also discusses some of the industry concerns surrounding FVA and Central Counterparties (CCPs). CCPs require conservative overcollateralization, with the amount of collateral exceeding that of a perfect collateral or a typical Credit Support Annex (CSA) with minimum transfer amounts (MTA) and/or collateral thresholds. That means that an excess amount of collateral must be borrowed in the market?creating a new funding cost. This is a major factor to consider when moving trades to central clearing. CCP causes a funding cost, which may exceed the benefit from the elimination of CVA, Dr. Sokol explains.

Wrong Way Funding Risk

 We are all familiar with the concept of wrong way credit risk, or wrong way risk for short (WWR) – the correlation of higher exposure with higher probability of default. In his presentation, Dr. Sokol introduced the concept of wrong way funding risk – the correlation between higher collateral funding requirement and higher funding cost, which may occur in a crisis. Wrong Way Funding Risk (WWFR) increases FVA and can significantly lower profitability of certain OTC transactions.

What’s Next?

From quants to traders, we are all intrigued by the novel topic of Funding Valuation Adjustment. Rocking the foundations of current quantitative financial theory, CSA/OIS discounting and FVA can no longer be ignored without consequences. In fact, some market practitioners feel so strongly about FVA’s relevance, that they believe it will make its way into future accounting and capital regulations including the next iteration of accounting guidelines and the Basel Framework.

Should derivative pricing remain independent of funding costs? Hull and White recently published a hotly debated paper in which they present arguments that funding costs have no place in risk-neutral valuation, but many others believe that soaring funding costs that dramatically affect the firm’s P&L are real and should be included in valuation. According to Numerix’s own Satyam Kancharla, SVP Client Solutions, “…firms that can get funding right in the current environment will enjoy ‘significant advantage.’ ”

And, so the debate lingers on…and probably will for some time. Stay tuned.

View the web conference, Deciphering FVA: Understanding, Modeling and Using 

Funding Value Adjustment now.

Register now for our upcoming webinar, To Hedge or Not to Hedge, That is the Question: Actively Hedging CVA and DVA.

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Improving Risk Management and Transparency for Structured Products

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