The FVA Debate. Should FVA Be Used for Valuing Derivatives?

The derivatives industry has been embroiled in a heated debate since the 2008 financial crisis over whether to incorporate funding value adjustments (FVAs) when valuing derivatives. As a financial risk management consultancy, it's crucial to understand the nuances of this debate and its implications for our clients.

What is FVA?

Funding value adjustment (FVA) is an adjustment made to the value of a derivative or derivatives portfolio to account for a dealer's funding costs. Proponents argue that FVA ensures a dealer recovers its average funding cost when trading and hedging derivatives².

The Case for FVA

Derivatives dealers advocate for FVA based on the following arguments:

It reflects real-world funding costs incurred by the trading desk.
It aligns valuation with the actual economics of the trade.
It helps recover costs charged by the bank's treasury department.

Many dealers have already implemented FVA in their valuation models, viewing it as a necessary adjustment to accurately price derivatives⁴.

The Case Against FVA

However, there are strong theoretical arguments against FVA:

Conflict with fair value accounting: Accountants worry that FVA leads to different banks pricing the same transaction differently, conflicting with fair value principles⁵.
Lack of theoretical basis: Finance theory suggests that the discount rate for valuing cash flows should be based on the risk of the project, not the entity's funding costs⁵.
Double-counting of risks: Some argue that FVA may double-count risks already captured in other adjustments like credit valuation adjustment (CVA) and debit valuation adjustment (DVA)¹.

The Middle Ground

Research by John Hull and Alan White suggests a potential compromise:

FVA may be justifiable only for the portion of a company's credit spread that doesn't reflect default risk⁵.
Banks should consider using two separate models: one for fair value accounting and another for internal performance measurement¹.

Implications for the Industry

The FVA debate has significant implications:

Pricing discrepancies: Banks with higher funding costs may become uncompetitive in certain types of transactions⁵.
Arbitrage opportunities: Differences in FVA practices could create arbitrage opportunities for end-users⁵.
Regulatory scrutiny: Inconsistent practices may attract increased regulatory attention.

Conclusion

As financial risk management consultants, we must carefully consider the pros and cons of FVA when advising our clients. While FVA reflects real-world funding costs, it also introduces complexities and potential inconsistencies in valuation.

The debate is far from settled, but the industry appears to be moving towards broader acceptance of FVA, albeit with ongoing discussions about its proper implementation². As consultants, we should stay informed about evolving best practices and help our clients navigate this complex landscape.

Ultimately, the decision to use FVA should be based on a thorough understanding of its implications, regulatory requirements, and the specific needs of each institution. As the debate continues, we must remain adaptable and ready to adjust our recommendations as new insights and industry consensus emerge.