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Webcast: The xVA Challenge - Derivatives Valuation in the Modern World

Speaker: Dr Jon Gregory

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A course on this topic is available in London, Hong Kong, New York, Singapore, Frankfurt, Stockholm, Sydney and Dubai

Webcast Agenda

  • Overview of xVA 
  • History of Counterparty Risk and CVA 
  • Funding and Collateral: FVA and ColVA 
  • Initial Margin and Regulatory Capital: MVA and KVA 
  • Pricing Examples and Optimisation opportunities 


1. You switch between FCA & FVA - is it correctly understood that FCA + DVA = FVA and thereby FBA could replace DVA?
A. Yes, this is broadly speaking correct and the general view in the market. FVA = FCA (funding cost adjustment) + FBA (funding benefit adjustment) and FBA is the same as DVA. There are however differences between FBA and DVA such as the credit curve used to compute them and netting assumptions. For these reasons, banks may use terms such as incremental FBA as I mentioned.

2. In the calculation of CVA, how reasonable is it to assume that the average positive or negative exposure at a time is equivalent to the expected cash flow at that time?
A. What you call the average positive or negative exposure, I tend to call the expected future value (EFV). The EFV is the discounted expected value of all future cashflows at a given time. This leads to more simple calculations (e.g. FVA under certain assumptions), where all that is required is to use a different discount rate.

3. It has been suggested that banks should not charge CVA+KVA but perhaps something like min. (CVA, KVA). Are you able to explain this? To me if a bank wants a perfect hedge they much hedge in the market (CVA) and this does not exempt them from seeing the KVA.
A. I think it has been quite common for banks to charge the larger of CVA+FVA or EL+KVA where EL represents some expected loss. The logic for this is that either we take the risk-neutral hedging approach (CVA+FVA) or the warehouse approach (actual expected credit losses and capital required). This potentially avoids the obvious complaint (from a salesperson for example) that they are having to charge the cost of hedging counterparty risk (CVA) and the capital required because it cannot/is not hedged (KVA). However, charging only CVA+FVA means the return on capital is zero & charging EL+KVA means that there are no funds to hedge CVA & FVA. Hence, I believe the correct treatment is to charge the full CVA+FVA+KVA, but where the KVA incorporated the capital relief that will be generated from CVA credit hedges. Banks have been gradually moving in this direction, but it is worth emphasising that any change that makes pricing more conservative is difficult to implement for obvious reasons. Many client trades also clear at a level which is broadly consistent with CVA+FVA only (i.e. apparently zero return on capital).

4. Should all these "VAs" only be taken into account for pricing purposes (at trading desk level, to take into account the potential costs/risks one trading desk could face in the future) or also be reflected in the balance sheet/accounts (and as a consequence be considered as part of the "fair value" of the derivatives)? 
A. Given that these are just kind of "costs" (or viewed as "transaction fees") associated to derivatives, it is not clear to me if we should take into account in financial statements.

I’m not an accounting expert and so I can’t really credibly argue what should be the correct valuation on the balance sheet/accounts of a firm. However, I do think the VA terms in general are more than the small costs (e.g. bid offer) we might usually think as representing the difference between prices and valuations. Furthermore, the fact that fair value used the exit price concept tends to drive VAs into the accounting valuation.

5. When do you think the new Basel CVA framework (based on the Fundamental Review of the trading Book) would go live?
A. It is very hard to know. The first Basel consultation paper (including the initial CVA capital charge) was in December 2009 and implementation began in 2013. The FRTB is taking longer than this. This gives some idea of the potential timescales.

Thank you to those attendees who submitted their questions.

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