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What is a Funding Value Adjustment?
Funding Value Adjustment (FVA) is an adjustment made to the valuation of derivatives or other financial instruments to account for the cost of funding the associated trades. It is a concept used in quantitative finance and risk management, particularly in the context of over-the-counter (OTC) derivative transactions.
The Funding Value Adjustment takes into consideration the fact that when trading derivatives, a party is required to fund the necessary capital to support the position. This funding cost can be attributed to several factors, including the cost of borrowing funds, the collateral requirements imposed by counterparties, and the capital charges imposed by regulatory frameworks like Basel III.
FVA also recognizes that when a trading desk enters into a derivative contract, it needs to allocate funds to finance the position. This capital requirement incurs costs, such as the cost of borrowing money or the opportunity cost of using capital for the trade. FVA also accounts for the credit risk associated with the derivative transaction. If the counterparty defaults, the funding costs and potential losses need to be considered in the valuation.
In many OTC derivative transactions, collateral is exchanged between counterparties to mitigate credit risk. The FVA incorporates the cost of posting collateral or the benefit of receiving collateral in the valuation. Additionally, regulatory frameworks like Basel III impose capital charges on banks and financial institutions. These charges depend on the riskiness of the derivative positions, and FVA incorporates these capital costs in the valuation.
FVA is typically calculated by modeling the cost of funding and taking into account the various factors mentioned above. The adjustment is applied to the fair value of the derivative contract to reflect the funding cost associated with the position. However, FVA is a complex and debated topic in quantitative finance, and different institutions may have varying methodologies and approaches for calculating and incorporating FVA into their valuations.
FVA is covered in more detail in module 6 of the CQF program.