stable relationship between bank funding rates, government rates and London
Interbank Offered Rate (LIBOR). As it transpires, funding costs/benets 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 denition 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
ofcially 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:
• Dening FVA.
• Computing FVA.
• Recognising funding costs and benets.