An article by Total Derivatives: Dr. Dmitry Pugachevsky, Director of Research at Quantifi, discusses the implications of FVA, the cost of hedging funds and FVA calculation.
In our previous article published in Total Derivatives (The impact of FVA on swaps - A primer) we introduced FVA - Funding Valuation Adjustment - and outlined different scenarios when it has to be calculated. We also demonstrated the role of wrong-way risk, including one arising from a correlation between the default risk of a bank and its counterparty. Here we describe the on-going industry debate on how to treat FVA – as a part of risk-neutral pricing or as an extra cost of a trade.
There is still industry discussion how best to calculate FVA. However, an even bigger debate is centered on the questions: assume that banks know FVA, how should they handle it? Should FVA be a part of the price, as in the case of CVA and DVA? Alternatively, should it be part of the cost attributed to a particular trade? In other words, can traders pass this cost to the counterparty, or should it be absorbed by the bank (and charged to the desk)? If it is included in price, how do you convince the counterparty to accept the cost arising from bank’s funding, and furthermore will it eventually lead to “natural selection” when banks with lower spreads win all the business?