Advanced Introduction: Unbalanced FVA

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In recent years, quants and practitioners have spent a great deal of time and energy explaining why Funding Valuation Adjustment (FVA) – the costs that arise when an unsecured transaction is covered by a secured transaction – should be part of the pricing of derivatives. They have been so convincing that at least 14 major banks are now including it in their public accounts, but although there is consensus at a high level, valuation and reporting practices remain a bit messy (Risk April 2013 and Risk April 2014).

In the first technique of this month, FVA accounting, risk management and negotiation of guarantees, Claudio Albanese, Managing Director of Global Valuation, Leif Andersen, Global Co-Head of Quantitative Strategy Group at Bank of America Merrill Lynch (BAML) and Stefano Iabichino, PhD Student and Analyst at Global Valuation, have put in place a rigorous accounting framework for the FVA, bringing order to what they consider to be improper practices within the industry, which includes reporting the FVA in profits.

Many banks currently divide FVA into a Funding Benefit Adjustment (FBA) – which occurs when a bank receives collateral from its hedging counterparty and does not have to remit it to the customer – and a cost adjustment. Funding (FCA), which reflects the costs that arise when the value of transactions is reversed. But this accounting method has its blind spots. It can ignore the risk of default of the bank or its counterparties, for example, and there is an annoying overlap between FBA and Debit Valuation Adjustment (DVA) – FBA and DVA see a bank record profits when its creditworthiness deteriorates.

In practice, banks also have the ability to remortgage the variation margin between transactions and counterparties, meaning that the benefits can be used to directly mitigate costs – a practice that is considered ignored in current accounting policies. of the FVA. The current practice is to calculate the FVA at the level of the compensation sets and then to aggregate it between them. The banks are left with a restatement of their results to reflect the adjustment.

The authors introduce a framework called FVA / FDA – with the new acronym standing for Debt Adjustment Financing. It extends the calculation of the FVA of the netting sets to a larger collection of unsecured transactions, where the cash received from the funding can be remortgage – what the authors call a “funding set”. They also show that FVA losses should not affect earnings and should instead be reflected in Common Equity Tier I capital.

If you have to finance derivatives by borrowing without collateral, you are hurting shareholders

The term FDA in this approach derives from the assumption that when a bank faces a cost of funding, someone else receives an equal benefit – in particular, in the case of unsecured derivatives, this is a transfer of internal wealth from shareholders to bondholders. So essentially FVA and FDA cancel each other out on the balance sheet, but the fact remains that shareholders, and traders for that matter, suffer because of the cost of funding.

“If you have to finance derivatives by borrowing unsecured capital, you are hurting shareholders because you are giving parts of the business to bondholders who can recover from a pool of unsecured derivatives if they default. from a bank. It will not change the value of the derivative. to the company as a whole, but it will be to the shareholders. From an accounting perspective, this can be reflected in equity rather than changing the overall market value of the derivative, ”says Andersen of BAML.

This year Risk Quants of the Year, Barclays’ Christoph Burgard and Bloomberg’s Mats Kjaer were among the first to perform FVA following a wealth transfer in their 2013 article, Funding strategies, funding costs (Risk January 2015, and Risk December 2013).

“In accounting, fair value is a rather vague and subjective concept. The authors took the bold decision to interpret fair value as the combined value to shareholders and senior creditors of the company. transfer from shareholders to senior creditors, fair value is not affected. This is consistent with Modigliani-Miller theory and the conclusions drawn in our article, ”says Bloomberg’s Kjaer, referring to the theory that the value of a business should not depend on how it is funded.

The remortgage-based method produces lower FVA deductions to equity than those based on current frameworks. In calculating the fund transfer pricing fee, the method also succeeds in eliminating the DVA due to the fact that it cannot be monetized by the trader – anything that has no shareholder value is gone. “It involves a lot of rethinking, because you have two notions of value for a derivative – how much companies benefit from it and how much shareholders benefit from it. This can be difficult to resolve and is tricky in managing incentives, but I think it reflects reality, ”says Andersen of BAML.

In our second technique, Storage credit risk: pricing, capital and taxation, Chris Kenyon, director of the quantitative CVA / FVA research team at Lloyds Banking Group in London, and Andrew Green, the team leader, extend Burgard and Kjaer’s semi-replication method to model the effects of l ‘storage of credit risk in pricing, also incorporating capital and tax effects.


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