Managing Derivative Funding
Risk - The FVA Debate
An Industry Thought Leadership Forum
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Managing Derivative Funding Risk - The FVA Debate
Professor Moorad Choudhry – Treasurer, Corporate
Banking Division, The Royal Bank of Scotland
Alexander Sokol – CEO, CompatibL and Founder,
Numerix
Etienne Koehler - Head of CVA Risk Modeling, HSBC
Robert McWilliam – Managing Director, Global Head
of CVA Desk & Collateral, ING Bank
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Managing Derivative Funding Risk The FVA Debate
Impact of collateral, CCP and
bilateral initial margin
Alexander Sokol, Numerix/CompatibL
PRMIA London
October 31, 2012
“Trading desk” view of FVA
● These slides define FVA narrowly as
the expected value of deal costs not
already included in MtM and CVA
○ The meaning of this definition radically
depends on which methodology is accepted by
the firm for MtM (OIS or LIBOR discounting)
and for CVA (unilateral or bilateral)
● Total economic effect of the deal for the
desk is then MtM + CVA + FVA
○ In many jurisdictions, only MtM and CVA can
be treated as P&L under accounting rules
“Trading desk” view of FVA contd.
● Additional assumptions implicit in this
practical definition of FVA
○ Hedging with another counterparty is included
only to the extent it is already part of the firm’s
definition of MtM (e.g. OIS discounting is based
on the assumption that the hedge is funded by
collateral posted under perfect CSA)
○ Any excess funding is provided by the firm’s
funding desk
Purpose of this definition
● This definition of FVA tells the desk
what the difference is between (a) the
total cost of managing the deal through
maturity, and (b) the sum of MtM and
CVA they can book as P&L according
to the firm’s accounting rules
○ We do not consider the complex arguments
related to shareholder value etc.
○ Desk here refers generically to all desks which
trade with this counterparty, but not the
funding desk or the rest of the firm
Traditional bilateral collateralization
● Under traditional bilateral
collateralization (e.g. CSA),
counterparties post collateral based on
current exposure for each netting set
○ Collateral agreement may be unilateral (one
party posts collateral) or bilateral (both parties
post collateral)
○ Collateral is posted on net basis – one party is
posting and the other receiving; parties do not
hold each other’s collateral
○ Collateral is posted for exposures above a
threshold
CCP initial margin requirement
● Central clearing reduces credit risk but
imposes new funding costs via
overcollateralization (initial margin)
○ To reduce credit risk, central clearing requires
the firm to post more collateral than the
exposure to cover for possible sudden
exposure increase in a crisis
○ The funds for collateral must be borrowed on
the open market, but receive lower CSA rate
(usually the OIS rate)
○ This eliminates CVA but creates FVA cost
in its place
BCBS margin proposal (BCBS226)
● Proposal to require margins based on
both potential future exposure (initial
margin) and current exposure (variation
margin) for non-cleared OTC trading
○ Initial margin should be exchanged by both
parties, without netting of amounts collected
by each party (i.e. on a gross basis). Amounts
legally segregated or held by custodian.
○ Very limited allowance for netting
○ Quantitative models or schedule for initial
margin; models calibrated to the period of
stress to reduce procyclicality
FVA and CSA with thresholds
● CSA or other “less than perfect”
agreements include thresholds which
reduce the amount of collateral relative
to perfect CSA
○ Funding cost (benefit) relative to OIS
discounted MtM for the side receiving (posting)
collateral
○ FVA moves the total in the direction from OIS
discounted price to unsecured (“LIBOR”)
discounted price
FVA and overcollateralization
● CCPs and BCBS 226 proposal require
overcollateralization; the amount of
collateral exceeds that of perfect CSA
○ Excess amount of collateral must be borrowed
in the market creating a new funding cost
relative to OIS discounted MtM
○ This funding cost may exceed the benefit from
the elimination of CVA, however CVA impact is
part of P&L but FVA is not, creating a large P&L
impact immediately due to the different
accounting treatment
PRMIA panel discussion
Managing Derivative Funding Risk - The FVA
Debate
31st October 2012
Etienne Koehler
(University of Paris 1 La Sorbonne)
Hull and White’s position
FVA = interest payments made above the risk free rate interests on the money
borrowed to manage a portfolio.
1. Discount must be done at the risk-free rate because it is required by the riskneutral valuation principle
2. If a dealer takes into account the DVA of the funding strategy, then the FVA
disappears, since FVA= DVA of the funding strategy
3. The DVA of the funding strategy is a benefit to shareholders, so it should be
taken into account
4. Even if a dealer does not take into account the funding strategy’s DVA, there
is no need for an FVA
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Some industry responses
1. Risk-free rate
Why not for the “building block” but one calibrates expressions of the
form ZC Bond * expected forward
2. If a dealer takes into account the DVA of the funding strategy, then the FVA
disappears, since FVA = DVA of the funding strategy
Theoretical computations say yes (e.g., cf. Morini)
3. The DVA of the funding strategy is a benefit to shareholders
- At least it shows a better balance sheet, hence better dividends, etc.
- What is the point if you have to wait for default to realize DVA?
- Buying back your debt probably not realizable more than once
4. Even if a dealer does not take into account the funding strategy’s DVA, there
is no need for an FVA
Not clear. True in the bilateral case as FVA ≈ 0
Link between hedging and FVA?
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Disclaimer
The views and opinions expressed in this presentation are those of the author alone and do not necessarily reflect the views or policies of HSBC Investment
Bank, its subsidiaries or affiliates.
HSBC BANK PLC
REGULATED BY FSA
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MEMBER HSBC GROUP
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