Calculating the effect of funding costs on OTC valuation using funding valuation adjustment

Abstract

The implementation of new regulations, including Dodd-Frank, MiFID II, EMIR and Basel III, is significantly increasing the cost of capital and forcing banks to re-evaluate the economics of their over-the-counter (OTC) trading businesses. Market best practice implemented by the most sophisticated banks now accurately measures all the components of a trade to analyse its profitability, including credit valuation adjustment (CVA), the cost of regulatory capital (CRC) and, most recently, funding valuation adjustment (FVA). Accurately measuring these components requires taking into account the OTC trades conducted across all desks with that counterparty, along with the collateral posted or received as part of any credit support annex (CSA). This is a significant new challenge for OTC businesses that has traditionally been siloed, often with separate front office analytics and systems. As these components span multiple trading desks, there has been a trend towards central measurement and management of these components by CVA desks with various strategies for allocating the profit/loss and risk of a trade between each trading desk and the CVA desk. FVA is the latest significant innovation in this area that captures the impact of funding and liquidity on the value of a trade. This value depends on the nature of the CSA (collateralised, uncollateralised or asymmetrical) and the net collateral posted or received.