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Here is another taste of the industry and research thought leadership that students can expect from the Master of Financial Risk Management program at the Rotman School of Management, University of Toronto. This is part 2 of two blog posts on valuation adjustments by world-renowned Professors John Hull and Alan White. Both professors teach in the MFRM program; students can expect to learn and interact directly with them in the program.

Valuation Adjustments 2

In this blog we continue our discussion of valuation adjustments by discussing the funding value adjustment (FVA). This is an adjustment to the value of a derivatives portfolio for the cost of funding the derivative positions. To illustrate how it might arise suppose that a derivatives dealer, Dealer A, has entered into a five-year interest rate swap with a corporate end user where it is receiving 3% and paying LIBOR. Suppose further that it has hedged its risk by entering into an exactly offsetting swap with another dealer, Dealer B, where it pays 2.9% and receives LIBOR.

Typically the transaction between the dealers will be cleared through a central counterparty (CCP). If the transaction with the end user were cleared through the same CCP, Dealer A’s situation is straightforward. The CCP will net off the two transactions so that they do not lead to any incremental initial margin requirement for Dealer A. Indeed, because the transaction always give a net positive value to the dealer, margin requirements should be slightly less than they would be without the two transactions.

But let us assume that the transaction between Dealer A and the end user is cleared bilaterally with no collateral being required while the transaction between Dealer A and Dealer B is cleared through a CCP. The transactions do then have some funding implications. First, the swap with Dealer B is liable to lead the CCP requiring additional initial margin from Dealer A during the life of the transaction. If we assume that the cost of funding initial margin is greater than the interest paid by the CCP on initial margin there is a cost to Dealer A in funding the incremental initial margin attributable to the transaction. This is sometimes referred to as a margin value adjustment (MVA) and will be discussed in more detail in our next blog.

The CCP’s variation margin can also lead to additional funding requirements similar to the initial MVA. Suppose that the transaction with Dealer B has a negative value to Dealer A so that the transaction with the end user has a positive value to Dealer A. Dealer A will have funds tied up in the variation margin it has posted with the CCP.1 It will not receive any collateral from the end user to offset this. This gives rise to a funding need because Dealer A has to increase its funding from external sources. In the opposite situation, where the transaction with Dealer B has a positive value and the transaction with the end user has a negative value, it receives variation margin from the CCP and does not have to provide any collateral or margin to the end user. This gives rise to…

To read the rest of this article, visit the FINCAD blog.

1 Although a CCP is in many ways similar to a futures clearing house the treatment of margin is different. When Dealer A pays variation margin to the CCP, it receives interest on it and when it receives variation margin it must pay interest on it. In the case of futures, no interest is paid on the margin.

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