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FVA was initially controversial in the quantitative finance community as is clear from the series of papers by John Hull and Alan White (2012b; 2012c; 2014b) and the responses to them by Castagna (2012), Laughton and Vaisbrot (2012), Morini (2012) and Kenyon and Green (2014c). The debate around FVA is discussed in section 1.4.1 and FVA models are presented in Part II; however, it is clear that most market practitioners believe a pricing adjustment should be made for the cost of funding unsecured derivative transactions. In this context FVA represents the costs and benefits from managing the collateral on hedges used to eliminate market risk from the unsecured transactions. FVA and CVA together can be viewed as the cost of not trading under a perfect CSA agreement. The accounting status of FVA is now in transition with increasing numbers of banks taking reserves.

Unsecured

As with CVA, unsecured trades are the standard case for FVA as both counterparties are fully exposed to each other. Symmetric models with both funding cost and benefits as well as asymmetric models with only funding costs have been proposed with a key determining factor being the potential overlap with DVA benefit. Broadly speaking, methodologies for FVA are either based on discounting, as noted earlier, or on exposure-based models that are extensions of CVA.

CSA

The discussion on residual exposure from CVA also applies in the context of FVA so that deviations from a perfect CSA could give rise to residual FVA. If we view FVA as the cost of providing an effective loan or the benefit of an effective deposit through a derivative then the residual exposure just gives rise to a residual funding cost or benefit. However, as will be discussed later, if we view the FVA as the cost of maintaining collateral on a hedge trade then the argument for residual FVA on CSA trades is much weaker, although funding costs and benefits will still arise from mismatches in collateral requirements due to differing CSA terms. What is clear is that FVA does not apply to the secured portion of the exposure unless the assets provided as collateral cannot be rehypothecated. Lack of rehypothecation may be due to legal terms within the CSA or because the asset provided as collateral may be ineligible under other CSAs.

CCP – Variation Margin

Given the degree of overcollateralisation for trades cleared through CCPs any residual exposure is likely to be small to zero. With this in mind the FVA component due to a mismatch between valuation and variation margin is likely to be close to zero.

Other Sources of FVA

Central counterparties also require that initial margin be posted in addition to variation margin. Large net risk positions can give risk to volatility buffers and all members of the CCP are required to contribute to a default fund that will be used to cover any losses in the event of the default of a member. All of this additional collateral needs to be funded through unsecured borrowing and hence gives rise to Margin Valuation Adjustment (MVA). Modelling the exposure at future times arising from these collateral buffers is complex. Initial margin is generally calculated using VaR models which means estimating expected future VaR. The volatility buffers use risk multipliers based on estimates of market depth so that large risk positions that cannot be quickly closed are penalised. The default fund, in the case of LCH, is based on all positions of all clearing members and so is very difficult to estimate as the positions of other members are unknown. In addition the methodology used by central counterparties is not always public, making models difficult to build.

The Basel Committee proposal on bilateral margin for financial counterparties BCBS 226 (2012h) and BCBS 242 (2013e) would similarly give rise to a funding requirement to maintain the initial margin collateral buffer.

Regulatory liquidity frameworks including FSA047/048 as applied in the UK (Financial Conduct Authority, 2014, section 12) and the liquidity framework under Basel III (BCBS, 2013b) also require the maintenance of an internal liquidity buffer to protect an institution from outflow in the event of a credit downgrade. This liquidity buffer has to be held in liquid assets by the bank against a two-notch downgrade of long-term rating by credit rating agencies. Many CSAs and ISDAs contain provisions for additional collateral in the event one or more rating agencies downgrade the counterparty below certain certain rating levels. In addition non-derivative products such as deposits may contain provisions to allow the counterparty to withdraw the deposit if the bank's credit rating falls below a certain level. The liquidity buffer must be funded through unsecured borrowing and hence is a type of FVA. Trades with counterparties that have embedded downgrade triggers in their documentation should include the cost of funding any additional liquidity buffer in the price of a new transaction.