FVA – Sailing on the uncharted waters

Author:Lukasz Prorokowski, Hubert Prorokowski
Position:Investment banking consultant, London, United Kingdom; University of San Francisco, San Francisco, California, USA
Pages:31-54
SUMMARY

Purpose - This report aims to investigate the approaches taken by financial institution to implement and compute the funding valuation adjustment (FVA). FVA can be defined as the incremental cost attributable to trades with non-collateralised counterparties. This cost emerges related to the need to fund the collateral calls associated with collateralised hedge trades. In this ... (see full summary)

 
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FVA – sailing on the
uncharted waters
Lukasz Prorokowski
Investment Banking Consultant, London, UK, and
Hubert Prorokowski
University of San Francisco, San Francisco, California, USA
Abstract
Purpose – This report aims to investigate the approaches taken by nancial institution to implement
and compute the funding valuation adjustment (FVA). FVA can be dened as the incremental cost
attributable to trades with non-collateralised counterparties. This cost emerges related to the need to
fund the collateral calls associated with collateralised hedge trades. In this respect, one common
challenge faced by banks relates to designing appropriate methodological approaches to compute an
FVA.
Design/methodology/approach – Recognising the growing importance of an FVA, this report is
designed to investigate different approaches to computing FVA and pricing funding costs into the
uncollateralised positions. Embarking on semi-structured interviews, the report explores the
methodologies and structural solutions utilised by global banks.
Findings – This report has indicated several inuential trends that shape the nascent FVA landscape,
as well as innovative initiatives undertaken by the banks to effectively use this metric. Going forward,
this paper has pointed to a number of current and future challenges faced by the participating banks
with regard to implementing the FVA.
Originality/value Before regulators make FVA punitive, unprotable or inadequate by
propagating the move to collateralised trading or introducing sanctions on banks recognising FVA in
their nancial statements, and thus reducing banks’ exposure to arbitrage opportunities, FVA will
remain a challenging metric for the banking industry in the near future. Therefore, it is pivotal to
understand any potential risks and operational difculties arising from “sailing on the uncharted
waters with FVA”. Moreover, it is necessary to understand market consensus on methodological
approaches to computing FVA, as well as practices around constructing the bank’s own cost of funds
curves.
Keywords CVA and DVA, Derivative pricing, Funding costs, FVA, Treasury,
Uncollateralised trades
Paper type Research paper
1. Introduction and study background
Economics and nance constitute very peculiar domains of science. With any other
science, we would reject theories that have been empirically tested to be false. However,
in nance and economics, we tend to ignore the empirics and rely on the theories that
have been refuted by recent events. This is particularly evident in the existing
assumptions underpinning the standard derivatives pricing theory of Black and Scholes
(1973);Merton (1973) and Hull (1997). Although the standard theory assumes that any
bank can still borrow/lend funds at a unique risk-free rate, the reality of markets has
changed years ago. To this point, market participants have realised that there is no
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
FVA – sailing
on the
uncharted
waters
31
Journalof Financial Regulation
andCompliance
Vol.23 No. 1, 2015
pp.31-54
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-01-2014-0005
stable relationship between bank funding rates, government rates and London
Interbank Offered Rate (LIBOR). As it transpires, funding costs/benets and inter-bank
liquidity require a thoughtful management that would utilise appropriate pricing
methods – Wood (2013). The search for the appropriate pricing methods triggered
fundamental changes in the discounting rates as banks have moved away from LIBOR
towards overnight indexed swap (OIS) discounting. Furthermore, the accelerating
change in the regulatory framework has prompted an unprecedented evolution in credit
valuation models (Becker and Cameron, 2013).
The aforementioned trend of fundamental changes in derivatives pricing has
undermined the well-established theories in nance and increased the openness of
nancial institutions for further changes. Against this backdrop, the latest change is
linked to the new approach to valuing uncollateralised and collateralised derivatives by
introducing the funding valuation adjustment (FVA). Whilst no nancial institution is
required by regulators to implement the FVA, banks are increasingly utilising this
valuation method in recognition of the aws of standard pricing methods for
uncollateralised trades, such as a widely criticised LIBOR at discounting (KPMG, 2013;
Hull and White, 2013;Tabb and Grundfest, 2013).
Recent years have witnessed an unprecedented debate on FVA and ways of
including funding costs into the derivative pricing and valuation. This paper attempts
to contribute to the complex debate on FVA by focusing on the major strides banks take
while complying with the new trend in derivative valuation. At this point, we recognise
the nascent phenomenon of compliance with peer practices that has been prioritised by
nancial institutions over conforming to the broadly criticised regulations.
There are many challenges to implementing the FVA, not least because there is no
standard denition for the FVA as of yet. Additionally, owing to the fact that it is a
relatively new pricing method, there is no market consensus on approaches to
computing the FVA. For example, it is still unclear whether banks should price funding
costs into uncollateralised trades. Moreover, factoring in the FVA with respect to the
credit valuation adjustment (CVA) and debit valuation adjustment (DVA) has not been
ofcially approved by the markets. Banks are not sure whether the FVA should be
hedged. It is still disputed whether the FVA risk should be accompanied by structural or
value at risk (VaR) limits. Finally, there is a long list of challenges that banks face when
using the FVA, which urged Hull and White (2012) and Burgard and Kjaer (2012) to
question the rationale behind utilising FVA to determine the value of a derivatives
portfolio or the sell/buy price levels for derivatives. All in all, among a number of equally
problematic VA’s in the banking sector (CVA, DVA, prudential valuation adjustment
and adjustments to derivatives prices), the FVA deserves a fresh analysis that would
facilitate a benchmarking tool for current trends and practices in this area.
Recognising the growing importance of FVA, this report is designed to investigate
different approaches to computing the FVA and pricing funding costs into the
uncollateralised positions. Embarking on semi-structured interviews, the report
explores the methodologies and structural solutions utilised by global banks. The
analysis of this topical research is broken down into the following sections:
Dening FVA.
Computing FVA.
Recognising funding costs and benets.
JFRC
23,1
32

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