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FVA sceptics lose ground in valuation debate 

February 5, 2016

Nazneen Sherif, Risk.net

The funding valuation adjustment, or FVA, is a bit like modern art. Everyone has a different take on it, stirring lengthy – and at times, heated – debates on how it should be interpreted. Some people rave about it, while some can't digest it at all, and others pretend to like it because of peer pressure. But despite this, there is a whole industry built around it.

Back in 2012, the argument was about whether FVA, which reflects the costs and benefits arising when uncollateralised derivatives are hedged with collateralised trades, should really exist. Dealers argued that it should, while academics angrily shook their heads.

For years, academics have argued that FVA breaks certain cherished financial principles that assume complete markets and perfect hedging. Under these assumptions, a perfectly hedged portfolio should grow at the risk-free rate. This rationale led them to conclude that derivatives should be valued by discounting cashflows at this risk-free rate. But dealers say markets are incomplete, because there is no liquid two-way borrowing and lending market – and as a result, derivatives should be valued using the bank's funding rate.

The fact that at least 29 major dealers have now accounted for the charge in their books should serve as evidence of which side is winning, but the reality is a bit more complicated.

Some banks cite peer pressure as the reason they chose to account for FVA in the first place. The numbers reported vary widely across the industry and bank disclosures on how they calculate the adjustment are sketchy at best. Added to this, a recent technical paper published on Risk.net showed that existing models overstated FVA by almost two times, sparking a huge debate as to whether current models need a revamp. Given these issues, it's not surprising that FVA is still on shaky ground. Read more

 
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