Incorporating Funding Value Adjustment in Valuation of Derivatives - A case study

Abstract

The derivatives market is a large, global market that fills an important function in the finan-cial system (Eklund et al., 2012). Before the global financial crisis in 2008, factors such as capital cost, funding cost and counterparty risk were hardly considered when pricing deriva-tives. Instead, the primary focus was to accurately price for the market risk in accordance with the transaction (Dennehy et al., 2013). After the global financial crisis, there was a change in how derivatives should be val-ued, partly on account of the risk-free rate. A new value adjustment, called Funding Value Adjustment, was introduced. Funding Value Adjustment takes its basis in estimating the un-derlying funding of the party providing the derivatives (Ernst & Young, 2012). Since the global financial crisis, Funding Value Adjustment has been an intensively debated subject in the derivatives market. At the moment there is a gap between the theoreticians and the practi-tioners. The general view of the theoreticians is that an incorporation of Funding Value Ad-justment is not to be recommended, while the practitioner’s mean that they are wrong, and that it should be incorporated (Kancharla, 2013). The thesis has mainly been based on inter-views in co-operation with a chosen institution from the industry, and also with other impar-tial actors. The purpose of the thesis is to determine if an incorporation of Funding Value Ad-justment in the valuation of derivatives shall be executed in the chosen institution. When bringing all aspects together there seem to be little doubt that an incorporation should be executed. All financial instruments valued at fair value should incorporate all rele-vant aspects when determining a fair value, including the funding cost. However, there are several factors that need to be taken into consideration regarding when it should be conduct-ed, i.e., when the timing is good. The uncertainties regarding what funding curve to use, and the discrepancy between the different departments (i.e., the Valuation department, Front Of-fice and Treasury) needs to be further investigated. The chosen institution also needs to assure that there is a common understanding and collaboration with regards to Funding Value Ad-justment in the different areas within the institution. Other factors, such as how the Nordic competitors act, and how the customers might react to an incorporation, needs to be assessed. To cope with these factors, it is suggested that the institution should put together a pro-ject group from the departments for a pre study. This study should analyse the factors and come with a solution of how and when Funding Valuation Adjustment should be incorporated in the Fair Value. Consequently, the conclusion from this case study is that the chosen institution should take immediate actions to start their incorporation. The institution need to understand and act on the factors mentioned above, and thus get ready, because now that their competitors have started to act, the institution need to be able to do the same.