by Abby Farson Pratt
Since the 2008 financial crisis, the derivatives industry has been embroiled in a controversy over whether to make funding value adjustments. A funding value adjustment (FVA) is an adjustment to the value of a derivative or a derivatives portfolio to ensure that a dealer recovers its average funding cost when it trades and hedges derivatives. In the May/June 2014 issue of the Financial Analysts Journal, John Hull and Alan White explore this controversy in their article, "Valuing Derivatives: Funding Value Adjustments and Fair Value."
We recently got the chance to talk with Hull and White about their research.
In theory, a dealer's valuation should not recover the whole of its funding costs. But in practice, many dealers are unconvinced by this argument and choose to make the adjustment anyway. "We thought that bringing a finance/economics approach to looking at FVA would be quite helpful, because most of the people in the industry have got very myopic perspectives as far as FVA is concerned," Hull said. "We wanted to take a big-picture finance/economics look at it and essentially look at the position of the bank as a whole, rather than just the derivatives desk."
Their research concludes that an FVA is justifiable only for the part of a company's credit spread that does not reflect default risk. An FVA can lead to conflicts between traders and accountants, and the types of transactions a bank enters into with end users depend on how high its funding costs are.
Hull and White are hopeful that the industry will gradually come to accept their findings. "There's been enormous pushback from the financial institutions, or from a large segment of them," White said. "They're deeply wedded to their belief that funding value adjustments should be made. It is still hotly debated in the industry as to whether this is the correct approach or not. John and I seem to be taking the lead on the anti-funding value adjustment arguments. But slowly we're winning converts."
Controversy over applying an FVA may persist, but Hull and White believe that the derivatives industry will find resolution. "I expect there will continue to be confusion in this area for quite a long time," Hull said, "but we're hopeful that these big-picture economic arguments will win out in the end."
To hear more about the authors' findings and their research's implications for banks and the derivatives industry, listen to the full interview or download the MP3.
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