Valuing Derivatives: Funding Value Adjustments and Fair Value

The authors examined whether a bank should make a funding value adjustment (FVA) when valuing derivatives. They conclude that an FVA is justifiable only for the part of a company’s credit spread that does not reflect default risk. They show that an FVA can lead to conflicts between traders and accountants. The types of transactions a bank enters into with end users will depend on how high its funding costs are. Furthermore, an FVA can give rise to arbitrage opportunities for end users.One of the most controversial issues for a derivatives dealer in the last few years has been whether to make what is known as a funding value adjustment (FVA)—an adjustment to the value of an uncollateralized derivative (or an uncollateralized derivatives portfolio) designed to ensure that a dealer recovers its average funding costs when it trades and hedges derivatives. In this article, we examine the arguments for and against FVA. We argue that it is correct for a derivatives dealer to take credit risk into account by making credit value adjustments (CVAs) and debit value adjustments (DVAs), but it is not correct for a derivatives dealer to attempt to recover the whole of its funding costs in its pricing and marking to market. It should attempt to recover only those funding costs that correspond to (1) the risk-free rate and (2) the part of its credit spread that is unrelated to default risk. The traders working for a bank are often charged the average funding cost on the funds they use. Therefore, it is natural for them to try to recover this cost in their pricing. In attempting to recover funding costs, however, they reduce their prices in such a way that they offer favorable prices on some transactions (e.g., the sale of options) and unfavorable prices on other transactions (e.g., the purchase of options). This outcome creates arbitrage opportunities for end users who are able to trade on an uncollateralized basis. An end user buys options from a dealer with high funding costs and sells them to a dealer with low funding costs.There are two components to the DVA for a bank’s own default risk. The first, referred to as DVA1, is an adjustment for the possibility that the bank will default on a derivatives portfolio with a counterparty. The second component, DVA2, is an adjustment for the possibility that the bank will default on the funding for the portfolio. DVA1 is always positive (a benefit to the bank). DVA2 is positive if the portfolio requires funding and negative if it does not.One argument against FVA concerns the relationship between FVA and DVA2. The default risk component of a bank’s credit spread is compensation provided to lenders for the possibility that the bank will default. Accounting bodies recognize this compensation as a benefit to the bank. If the whole of a bank’s credit spread is compensation for default risk, FVA and DVA2 cancel each other and thus it is correct to consider neither in pricing derivatives. In other situations, basing an FVA on the non–default risk component of the credit spread is justifiable.Another argument against FVA concerns fair value accounting, which aims to mark derivatives portfolios to market at exit prices. The exit price for a dealer’s portfolio with a counterparty cannot depend on the dealer’s funding costs. It will depend on the market prices that reflect CVAs and DVA1s. Some argue that funding costs have moved markets away from the “law of one price.” We argue that this notion is not valid. Only one price clears the market for any given product, particularly when the product can be either bought or sold. A troubling aspect of FVA is that it results in different market participants having different estimates of fair value.Some market participants incorporate FVA, but not DVA1, into their pricing. Although this practice is better than incorporating both, it is not the correct solution. It leads to a dealer’s pricing of uncollateralized transactions being out of line with the market in such a way that the dealer offers favorable prices on some transactions and unfavorable prices on others.