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Funding value adjustment

What Is Funding Value Adjustment?

Funding value adjustment (FVA) is a valuation adjustment applied to the pricing of financial instruments, primarily in the context of derivatives. It falls under the broader category of derivatives valuation, which involves complex calculations to determine the true cost or benefit of these contracts. FVA quantifies the incremental cost or benefit incurred by a financial institution in funding or being funded for the uncollateralized portion of its derivatives positions. This adjustment accounts for the difference between a bank's actual funding cost and a theoretical risk-free rate, impacting the true profitability of over-the-counter (OTC) derivative trades. The concept of FVA has gained prominence as financial institutions strive for more accurate and comprehensive pricing of their financial exposures.

History and Origin

The concept of funding value adjustment emerged prominently in the wake of the 2007-2009 global financial crisis. Prior to the crisis, derivatives were often valued using models that assumed banks could borrow and lend at a common, near risk-free rate, such as LIBOR. However, the crisis led to significant disruptions in the interbank funding market, causing bank borrowing rates to diverge substantially from risk-free benchmarks due to increased concerns about bank creditworthiness. As a result, the cost of funding for derivatives desks increased significantly. Financial institutions began to recognize that the traditional valuation methodologies did not adequately capture these real-world funding costs and benefits. This spurred the introduction of various "XVA" adjustments, including FVA, to reflect these additional costs and risks in derivatives pricing and financial reporting. For instance, a paper by Darrell Duffie and Nicolae Garleanu from the Bank for International Settlements (BIS) discusses the theory of funding value adjustments for the costs to dealer banks of financing necessary cash for financial positions like swaps.5

Key Takeaways

  • Funding Value Adjustment (FVA) accounts for the cost of funding uncollateralized derivatives positions.
  • It emerged as a critical adjustment post-2008 financial crisis due to increased bank funding costs.
  • FVA impacts the profitability and pricing of derivatives trades for financial institutions.
  • The calculation of FVA involves considering a bank's specific funding rates and the present value of expected future funding costs or benefits.
  • FVA is a debated topic, particularly concerning its consistency with fair value accounting principles.

Interpreting the Funding Value Adjustment

Interpreting the funding value adjustment involves understanding its impact on the profitability and pricing of derivatives transactions. A positive FVA indicates an additional cost to the financial institution, meaning the funding associated with the derivative position is more expensive than a benchmark rate. Conversely, a negative FVA (often referred to as a funding benefit adjustment or FBA) implies a benefit, where the derivative position provides a funding source. For example, if a bank enters into an OTC derivative contract that requires it to post collateral, it incurs a funding cost for that collateral. This cost is captured by the FVA. The magnitude of FVA can be substantial, influencing a bank's overall balance sheet and reported earnings, particularly for institutions with large derivatives portfolios. It directly affects how a derivatives desk evaluates the economic value of a trade and its contribution to shareholder value.

Hypothetical Example

Consider a financial institution, "Bank A," entering into a five-year uncollateralized interest rate swap with a corporate client. The notional principal of the swap is $100 million.

  1. Initial Valuation: Based on standard derivatives pricing models using a risk-free rate, the swap initially has a fair value of zero for both parties.
  2. Funding Costs: However, Bank A's funding desk borrows at a rate of OIS + 50 basis points (0.50%) due to its specific credit risk and market liquidity conditions, while it receives OIS on any collateral it posts or receives. Since this is an uncollateralized trade, Bank A needs to fund the potential future positive mark-to-market value of the swap from its own balance sheet if the swap moves in its favor. This funding cost is specific to Bank A and is not reflected in the generic risk-free valuation.
  3. FVA Calculation: Over the five-year life of the swap, Bank A anticipates periods where the swap will have a positive market value from its perspective, meaning it would need to fund that exposure. The present value of these expected future funding costs, discounted at Bank A's own funding rate, would constitute the FVA.
  4. Pricing Impact: If the calculated FVA is, say, $500,000, Bank A would incorporate this into its pricing of the swap with the corporate client. To recover this funding cost, Bank A would adjust the fixed rate on the swap slightly to ensure the expected revenue covers its FVA. This ensures that the trade is profitable after accounting for Bank A's actual cost of capital.

Practical Applications

Funding value adjustment plays a crucial role in modern financial risk management and derivatives trading. It is extensively used by major financial institutions, particularly those with significant exposure to uncollateralized over-the-counter derivatives.

  • Derivatives Pricing: FVA is integrated into the pricing models for complex derivatives, alongside other valuation adjustments like Credit Value Adjustment (CVA) and Debit Value Adjustment (DVA), to arrive at a more comprehensive "XVA" price. This allows banks to quote prices that reflect their true cost of funding and managing these instruments.
  • Profitability Analysis: Traders and risk managers use FVA to assess the actual profitability of trades. A trade might appear profitable based on traditional risk-free valuation, but turn unprofitable once the funding costs (FVA) are factored in.
  • Capital Allocation: By providing a clearer picture of the true costs, FVA helps banks in more efficient capital allocation decisions. Regulatory frameworks like Basel III also influence these capital requirements, prompting banks to consider all valuation adjustments.4
  • Hedging Strategies: Understanding the FVA component helps in designing more effective hedging strategies, especially for portfolios of uncollateralized trades where funding mismatches can occur between client trades and their collateralized hedges in the interbank market.

PwC Australia has noted that the introduction of various valuation adjustments, including FVA, has had a genuine impact on earnings across the banking industry, with some major global investment banks reporting significant losses due to funding valuation adjustments.3

Limitations and Criticisms

Despite its widespread adoption by practitioners, funding value adjustment remains a subject of considerable debate and criticism within the academic and regulatory communities. One primary point of contention revolves around whether FVA represents a true market value adjustment or an internal cost allocation.

  • Fair Value Accounting: Critics argue that including FVA in derivative valuations may violate the principle of fair value, which posits that an asset or liability should be valued at an "exit price" – the price at which it could be exchanged between knowledgeable, willing parties in an arm's length transaction. They contend that FVA, being specific to a bank's own funding costs, introduces subjectivity and a departure from a universally agreed-upon market price. This concern about consistency with fair value accounting is a significant limitation.
    *2 Arbitrage Opportunities: Some academics, such as John Hull and Alan White from the University of Toronto, argue that applying FVA can lead to theoretical arbitrage opportunities for market participants, particularly if different institutions apply different FVA calculations. They maintain that the risk of an investment should drive its valuation, not how it is funded.
    *1 Double Counting: There are also concerns about potential "double counting" when FVA is considered alongside other valuation adjustments like Debit Value Adjustment (DVA), as both relate to aspects of a bank's own creditworthiness.
  • Methodological Complexity: The calculation methodologies for FVA can be highly complex and vary significantly across institutions, leading to a lack of standardization and transparency. This complexity can make it challenging to compare valuations across different banks and may introduce a degree of market volatility in pricing.

Funding Value Adjustment vs. Debit Value Adjustment

Funding Value Adjustment (FVA) and Debit Value Adjustment (DVA) are both valuation adjustments applied to financial instruments, particularly derivatives, but they address different aspects of credit and funding.

Debit Value Adjustment (DVA) accounts for the credit risk of the bank itself (the reporting entity). It represents the benefit a bank receives because its own debt obligations become less valuable when its credit quality deteriorates. If a bank's credit spread widens, its derivative liabilities become less costly to fulfill, resulting in a gain. DVA is a controversial topic, with accounting standards generally requiring its derecognition from Common Equity Tier 1 capital.

Funding Value Adjustment (FVA), in contrast, accounts for the cost or benefit of funding the uncollateralized mark-to-market exposure of a derivative. It arises from the difference between the rate at which a bank can fund itself and the rate at which collateral is remunerated (often a risk-free rate). While DVA relates to the benefit of one's own credit deterioration on liabilities, FVA specifically addresses the actual financing costs or benefits associated with maintaining derivatives positions, particularly when those positions are not fully collateralized. The debate often centers on whether FVA truly represents a fair value adjustment, unlike DVA, which is clearly linked to changes in the bank's own credit risk.

FAQs

Why did FVA become important after the 2008 financial crisis?

Before the 2008 financial crisis, it was often assumed that banks could borrow and lend at a single, consistent risk-free rate. However, the crisis caused significant spreads between bank borrowing rates and risk-free rates due to increased perceptions of bank credit risk. This meant that the actual cost for banks to fund their derivatives portfolios diverged from the theoretical risk-free assumption, making FVA necessary to reflect these real funding costs.

Is FVA always a cost to the bank?

No, FVA can be either a cost or a benefit. It is a cost (Funding Cost Adjustment, FCA) when a bank needs to fund a positive mark-to-market position for which it has not received collateral. It can be a benefit (Funding Benefit Adjustment, FBA) when a bank holds a negative mark-to-market position and effectively receives funding from its counterparty, which it can then use to offset its own borrowing needs.

How does FVA relate to other valuation adjustments like CVA and DVA?

FVA is one of several valuation adjustments, collectively known as XVA (e.g., CVA, DVA, MVA, KVA). While Credit Value Adjustment (CVA) accounts for the counterparty's credit risk (the risk that the counterparty might default), and Debit Value Adjustment (DVA) accounts for the bank's own credit risk, FVA specifically focuses on the cost of funding or benefit of being funded for the uncollateralized portion of derivatives trades. These adjustments are applied to the fair value of a derivative to arrive at a more comprehensive and economically realistic price.

Is FVA universally accepted in finance?

No, FVA is a highly debated topic. While it has been widely adopted by financial institutions for internal pricing and risk management purposes, there is ongoing discussion among academics, practitioners, and regulators about its theoretical coherence, particularly regarding its consistency with fair value accounting principles and the possibility of creating arbitrage opportunities.