Funding Value Adjustments

Abstract

In this paper, we demonstrate that the funding value adjustments (FVAs) of major dealers are debt overhang costs to their shareholders. To maximize shareholder value, dealer quotations therefore adjust for FVAs. Our case studies include interest‐rate swap FVAs and violations of covered interest parity. Contrary to current valuation practice, FVAs are not themselves components of the market values of the positions being financed. Current dealer practice does, however, align incentives between trading desks and shareholders. We also establish a pecking order for preferred asset financing strategies and provide a new interpretation of the standard debit value adjustment.

Binary funding impacts in derivative valuation

“…This result supports a part of the conclusion in Andersen et al. (2019) that DVA should be considered in pricing.…”

“…According to the Modigliani‐Miller (MM) theorem, choices of funding should not be considered in pricing (Modigliani & Miller, 1958; Stiglitz, 1969). In practice, traders feel confident that funding costs are observable in derivative transactions (see Andersen, Duffie & Song, 2019). As pointed out by Hull and White (2012), however, if funding rates are truly an element to determine derivative prices, the existence of Treasury bonds is enigmatic because banks purchase Treasury bonds that return less than their funding rates.…”

Hedging the Treasury Lock

“…As for the FVA (Andresen, Duffie and Song [21], Morini and Prampolini [20], Albanese and Andreasen [22]), having noticed that the natural hedge is a repo trade, a funding cost arises from the cash leg of the hedge the Bank is posting to borrow the security or from the collateralization mechanism if the repo is CSA-assisted or cleared.…”

Negative Swap Spreads and Limited Arbitrage

“…So far, this literature has not considered interest rate swaps. 1 Empirical studies have documented the drivers of swap spreads with factor models, in particular Liu, Longstaff and Mandell (2006) and Feldhuetter and Lando (2008). More recently, Hanson (2014) documents the relation between MBS duration and swap spreads.…”