Funding valuation adjustment

What Is Funding Valuation Adjustment?

Funding valuation adjustment (FVA) is an adjustment made to the fair value of a financial instrument, typically derivatives, to account for the cost or benefit of funding that instrument over its lifetime. It falls under the broader category of Derivatives Valuation adjustments, often grouped with other "XVA" adjustments such as Credit Valuation Adjustment (CVA) and Debit Valuation Adjustment (DVA). FVA reflects the incremental cost of funding uncollateralized or partially collateralized positions that a financial institution, like a bank, must bear when entering into derivatives transactions.⁴⁴, ⁴⁵ Essentially, it captures the difference between a bank's internal funding rate and the benchmark risk-free rate used for pricing.⁴², ⁴³

History and Origin

Prior to the 2008 global financial crisis, market participants commonly used the London Interbank Offered Rate (LIBOR) as both a proxy for the risk-free rate and the cost of funding. However, the crisis led to significant increases in spreads on bank debt, making financing activities much more expensive for derivatives desks.⁴⁰, ⁴¹ This period also saw a divergence between LIBOR and Overnight Index Swap (OIS) rates, with OIS becoming the preferred discount rate for collateralized transactions.³⁹

The uncoupling of these rates and the heightened awareness of funding costs highlighted a gap in traditional derivatives pricing models, which largely assumed funding at a risk-free rate.³⁷, ³⁸ Consequently, banks began to implement funding valuation adjustment to explicitly account for these real-world funding costs and benefits, particularly for over-the-counter derivatives (OTC) that are not fully collateralized. This shift marked a significant evolution in derivatives pricing and risk management practices, driven by both market realities and subsequent regulatory pressures to ensure more accurate reflection of balance sheet costs.³⁵, ³⁶ The emergence of FVA sparked considerable debate among academics, regulators, and practitioners regarding its theoretical justification and practical application.³⁴

Key Takeaways

• Funding valuation adjustment (FVA) quantifies the cost or benefit of funding a financial institution's derivatives positions, particularly uncollateralized ones.
• It emerged prominently after the 2008 financial crisis due to increased bank funding costs and the divergence of interbank lending rates from risk-free rates.
• FVA is part of a suite of "XVA" adjustments, which collectively aim to account for various real-world costs and risks beyond traditional risk-neutral pricing.
• The calculation of FVA considers the difference between a bank's cost of funds and the collateral rates paid by clearinghouses or used in interbank markets.³³
• FVA can represent either a cost (Funding Cost Adjustment, FCA) or a benefit (Funding Benefit Adjustment, FBA) depending on whether the derivative position is an asset or a liability for the bank.³²

Formula and Calculation

The calculation of Funding Valuation Adjustment can be complex, often requiring sophisticated models that consider future exposure, probabilities of funding drawdowns, and the bank's own funding spread. Conceptually, FVA represents the present value of all expected future funding costs or benefits associated with an uncollateralized derivative position.

A simplified representation of FVA can be given by:

Where:

• $\text{FVA}$ = Funding Valuation Adjustment
• $\text{DF}(t_i)$ = Discount Factor at time $t_i$
• $S_B$ = Bank's funding spread (cost of internal funding)
• $S_C$ = Collateral rate (e.g., OIS rate, rate paid by clearinghouse)
• $$$$