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September 3, 2013

Derivatives Funding Dynamics: FVA & The Hidden Cost of Trading

Risk analytics can be a bit like alphabet soup. In this video blog, Numerix VP of Client Solutions defines CVA, DVA and FVA. and explains how they fit together in the marketplace. He stresses that Funding Value Adjustment. in particular, can dramatically impact the profitability of a trade. He and TABB senior analyst Paul Rowady take a deep dive into the evolution of derivatives funding costs and the role of FVA, exploring what it is, who it impacts, and why they should care.

Watch the Video: Derivatives Funding Dynamics: FVA & The Hidden Cost of Trading

 

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Video Transcript: Derivatives Funding Dynamics: FVA & The Hidden Cost of Trading

Paul Rowady (Host). So I know what youre thinking, but this is not Hedrik Sedin and were not talking about the epic failure of the Vancouver Canucks in the, what year was it, 2011 Stanley Cup Finals? 

Tom Davis (Guest): Sure, yes that is true.

Rowady: No were going to talk about something far more interesting. Im here with Tom Davis, Vice President and Client Solutions for Numerix.

Today, were going to explore a little bit of the alphabet soup, thats coming around in risk analytics having to do with CVAs, and DVAs, and FVAs. With CVAs the credit valuation adjustment being the most well-known or at least the most talked about of this new alphabet soup, but I thought we would have Tom level set a little bit.

What are these different pieces, and then were going to talk a little bit more specifically about the funding valuation adjustment, FVA, what is it, who does it impact, and why should they care? So why dont we start with the top level of the alphabet soup and how these different pieces now fit together in the transforming marketplace.

Davis. Sure. Thanks for having me Paul. The CVA, is the charge that you put on based on whether or not your counterparty is going to default. So it is something that you put on the trade and you can actually hedge it throughout the lifetime of the trade. And it harkens back to the credit spread that you use to put on counterparties. But nowadays people are much more sophisticated and they can hedge it, and track it throughout the lifetime of the trade. And so, that is something that in principal, you and I, if we go into a deal, we could agree upon what charge that should be and its a balance sheet statement actually now.

DVA is a similar thing; but its looking towards me. So if I go into the trade with you the DVA is the – your CVA if you were doing the trade with me, that is what I write down as my DVA. So again, thats something in principal we would agree upon at the start of the trade.

Rowady: Now I just want to break in a second. When we say a deal is this purely, a swap trade, or what are the examples of the products where this would come into play?

Davis: Thats the bilateral markets. The clearing houses have their own ways of getting into this sort of protection.

Rowady: Right. Well get into that in a second.

Davis: Right, well the DVA and the CVA are things that we can agree upon on the outside of the trade. And FVA is another thing that has come out recently as what use to happen is if we enter the trade, I would ask my treasury desk, how do I fund this or what is my funding cost? And they would say, oh its Citibank, give them one hundred basis points for instance, or theyd just look up basically, in their netting sets and see who theyre exposed to.

But now just like the credit charges being more sophisticated, more calculated, and in a more sophisticated manner, so is the funding charge. So this funding value adjustment literally looks at how youre going to fund the trade. Are you going to get it at the risk free rate from your collateral account? Are you going to go into the market and get what your market can give you, to make sure you meet the future cash flow obligations? And you roll that all up into the funding value adjustment charge.

Rowady: How much of the profitability of a bilateral swap trade for instance will the FVA represent? Is there a range or is it just too variable to track down as to — how important is it to really get this right?

Davis: It certainly is something that you want to know about at the start of the trade. It can really affect the profitability. And one thing that is also – the reason I cant give a definitive answer like a thirty year swap is fifty basis points is because it depends on the netting set. So its something that were going to have to, if I have a lot of trades on with you – net our whole exposures and then do the calculations of the FVA. 

Rowady: Right.

Davis: So its something that if you have a lot of trades on with the counterparty it could be significantly reduced. So thats important for the buy-side, when they go to broker dealers to get their trades, they could find a significant variation in the cost that theyre being quoted in the market.

Rowady. And in terms of who should care about this if Im a dealer or Im an asset manager at a hedge fund, or Im a corporation, do I have different challenges, different cares. Am I maybe behind the eight ball if Im one of those players versus a dealer that might be, more able to calculate this kind of a number more regularly with more accuracy.

Davis: Every trader should really care because it definitely affects their P&L. And so as John Hull recently said, theyre going to respond to the incentives that theyre given, and that means theyre going to have to pass on that charge if possible, theyll always want to pass on that charge.

Now, whether they can or not is going to depend on the market conditions. If youre in the interdealer market, so a bank to bank, youre probably not going to be able to pass on this charge. But its still something that you have to know, because its going to be a P&L item from your funding desk.

On the buy-side, its something that you should be aware of; its probably not something that youre going to be calculating on a daily, weekly basis. But its something you should be aware of so that you know the factors that mitigate it. Like a lot of trades with a certain counterparty, or the credit quality of the counterparty, so these inputs to the calculation are things that youre going to try to minimalize.

Now its an interesting question that you brought up the hedging aspect of it. CVA, you can hedge. Theyre desks; weve seen in a lot of the Tier I Banks, theyre hedging CVA. And thats something that you can do. The CCDS or proxy CDS. But DVA is something thats very difficult to hedge or some people say impossible. Youd have to do some sort of proxy hedging.

Rowady: And thats just you know, just to make it perfectly clear, thats because I cant engage, I cant get into a specific CDS on myself.

Davis: Thats correct.

Rowady: So I have to find a proxy and typically at least among the major dealers, there may not be one thats exactly my proxy, at least over the life of some trade. There might be a periodic good proxy but the cost of changing your proxy throughout the life of the trade is probably not going to be, its going to be cost prohibitive.

Davis: Thats right. But FVA is something that you also cannot hedge. Because, what you would have to do to hedge it is basically, find instruments that mimic this FVA or at least you can construct a portfolio that mimics it.

Or you go back to your counterparty and say market conditions have changed, I need you to give a bit more money to me because I need to fund my derivative differently now. Thats something that you just cant do to your counterparty. And so you can think of it almost like as an initial margin calculation that you could tack on to a derivative. That would be one way to mitigate the FVA. The other is a running spread, however, its a little bit more complicated because then that affects the profile of the derivative in the future. And then you have to redo your FVA calculation.

Rowady: Not to throw more acronyms in here but does a CSA, our credit support annex. you know like a CCP can change your margin rules on the fly, I mean they may come up with a different calculation you have to post more margin. Why couldnt you if your FVA changes, as the counterparty my CSA may allow me to say you know what, I think I need to change the margining or the collateralization of this bilateral trade that we have on. Does it not allow that flexibility?

Davis. The CSAs are becoming more and more standard because once people saw how collateral really affects the funding of the derivative, they started scrutinizing the CSAs and ISDAs coming out with standardized CSAs for all the different trades that fall under ISDA. Nothing right now in that has something like this in it, where if such an event happens, then you post more. Actually I should take that back a little bit. There is some break clauses that if your credit rating changes then the CSAs do allow for this margining.

Rowady: Yeah but you can have changes, significant changes in FVA without credit events.

Davis: Absolutely.

Rowady: So it sounds like thats not going to be, at least the way its structured now, you wouldnt have reason to be able to go and ask for more what would essentially be initial margin.

Davis: Correct, right. Theres no clauses right now in CSAs.

Rowady: This is an obvious need for bilateral transactions but there are situations, even as clearing adoptions become more pervasive in some of the more vanilla end of the spectrum in terms of the product spectrum and over the counter derivatives that this topic comes into play. Maybe you can go into a little bit of that.

Davis: Yeah definitely. All the clearing houses have moved to whats called overnight discounting which means the rate you discount your future cash flows is the overnight index swap in your different jurisdictions. So all of the clearing houses have adopted this and even regulators recently have come out and said that this is the way to do things.

Rowady: Versus LIBOR?

Davis: Versus LIBOR. precisely. But why you still have to worry about FVA even in the clearing house situation, is that, that overnight discounting actually assumes daily margining or even more frequent margining which is something that doesnt happen. So as your margining lags, the market movements in your derivative, this is where FVA comes into play. And if you have cash flows that are more frequent than your margining, or how often you repost collateral, then youre not funding purely at the overnight rate which is whats assumed by this overnight discounting.

Rowady: Okay. I think were going to bookmark it there. Thats a lot to absorb for most of us. There are probably some folks that want to get back to talking hockey but maybe well do another video on that some time. I want to thank Tom Davis from Numerix. Im Paul Rowady, Senior Analyst here at TABB Group. Thanks for watching.