FVA arises when the bank has an unsecured trade with a counterparty and hedges it, via a secured trade, with a riskless counterparty. In which case if PV of the trade is positive, PV of the hedge is negative, and to cover margin/collateral call the bank has to borrow cash at its funding rate LIBOR+s where ‘s’ is a funding spread. The trade, and therefore funding, terminates if the bank or a counterparty defaults. FVA is the expected value of the funding cost. It can be expressed as expectation of the bank’s funding spread applied to positive PV (discounted to today) until deal maturity, or early termination due to bank or counterparty default.
An ongoing industry debate centres on whether traders include FVA in price and pass it to the counterparty or whether it should be absorbed by the bank. To avoid considerable FVA costs, banks must attempt to reduce their borrowing rate, in addition to choosing trades that minimise funding costs. In any case, it is imperative to have a margin profitability calculator which compares trade P&L (quoted price after subtraction of risk-neutral price and bilateral CVA) with FA and other incurred costs, including regulatory capital charges. Following this analysis, only then can a decision to execute any particular trade be made.
