POST-CRISIS

DERIVATIVES VALUATION
ACT III: FUNDING VALUATION ADJUSTMENT

MAZARS THOUGHT LEADERSHIP / 2015

“ IN LIGHT OF THE TEACHINGS OF THE FINANCIAL

CRISIS, BANKS HAVE CONSIDERABLY REVIEWED THE WAY
DERIVATIVES ARE VALUED. INSTITUTIONS ARE CURRENTLY
DEVELOPING METHODOLOGIES THAT CONSIDER ALL THE
COSTS AND RISKS RELATED TO DERIVATIVES ACTIVITY.
 POST-CRISIS DERIVATIVES VALUATION
ACT III: FUNDING VALUATION ADJUSTMENT

I
n light of the teachings of the financial THE ACTUAL PROBLEM
crisis, Banks have considerably
reviewed the way derivatives are While institutions are continuing to
valued. Institutions are currently enhance their estimation of the above
developing methodologies that consider elements, a consensus seems to be
all the costs and risks related to emerging on how the cash flows of the
derivatives activity. non-collateralized derivatives are to be
discounted. Discounting assuming a
• Initially, this has been particularly short-term financing of these positions
reflected by the Credit Valuation (EURIBOR 3M rates were used as
Adjustment (CVA) and the Debit / reference) has been abandoned by
Debt Valuation Adjustment (DVA) that institutions that observe that the prices
account for the credit risks to which of derivatives transactions appear to
each counterparty are exposed. incorporate more long-term liquidity
• Secondly, the rates used to discount risks.
the cash flows of the collateralized
Christophe Bonnefoy derivatives have been defined in In this article, we first propose to
Senior Manager
accordance with the rates used to illustrate this problem by bringing out
Quantitative Analyst & Actuary at Mazars
value the exchanged collateral, usually the reasons why these costs might
the OIS1 . have to be taken into account; secondly,
we study the normative requirements
governing the determination of the
1 European reference for the over- discount rate; and finally, we propose a
night rate (swaps indexed on the methodological approach.
EONIA : Euro Overnight Indexed
Swaps)

A BRIEF SYNOPSIS
> Several Top Tier Banks have already taken into account the funding costs of their
non-collateralized derivatives by recording a Funding Value Adjustment (FVA) in their
financial statements.

> The main impact of the FVA is a negative discount applied to current (and
potential future) assets. The impact of the FVA on the liabilities has been almost fully
considered through the DVA (Debt Value Adjustment) calculation.

> The current norm recommends to value a position as two market participants
would have done so. Hence, the valuation should not be tied to the funding cost of a
specific entity which is preparing its financial statements. Theoretically, it will be very
difficult for most market participants to observe transactions defining the market
“derivative funding” spread level.
 POST-CRISIS DERIVATIVES VALUATION
ACT III: FUNDING VALUATION ADJUSTMENT

1. FUNDING COSTS FOR THE NON-COLLATERALIZED DERIVATIVES

In this section, we seek to economically highlight the ments;
presence of financing costs inherent to non-collateralized • Bank « B » is a participant representing the market,
derivatives positions. the derivatives funding spreads of “B” are non-entity
specific, they reflect what is observed on the transaction
For the purpose of our illustration, we assume that the being operated in the market.
valuation of the derivative does not change sign over the
lifetime of its position. We will relax this hypothesis, in Let us further assume that the Banks finance themselves
order to study a more general framework, in section 3 by with the following derivatives funding spreads (i.e. those
considering potential exposures. used to value derivatives, observed on derivatives tran-
sactions and potentially different from the classic funding
Let us consider the following assumptions to study the spreads).
case of a transfer of derivatives between two Banks: In the two cases studied, one assumes short-term funding
• Bank « A » is the one preparing is financial state- and the other assumes long-term funding:

1.1 STUDY OF A SWAP RECOGNIZED AS AN ASSET

Let’s study the case where Bank «A» sells to Bank «B» a the financing costs tied to the derivative it is carrying.
swap recognized as an asset (whose MtM is positive). Also,
let « C » be the counterparty of « A ». The way the swap is valued in this transaction will depend
For instance, « A » is committed to pay to its counterparty on the way the liquidity is managed / charged by the
« C » 1% per year for 5 years, while the 5 year market different market participants. According to our assump-
swap rate is 3%: « A » earns 2% per year for 5 years and tions, the cost over the EURIBOR 3M is null if the liquidity
hence the MtM of the swap is positive. is considered from a short-term point of view. However, «
B » will undergo a cost of 25 bps in the absence of FVA if
Therefore, it is clear that setting this transaction liquidity is long-term financed.
consumes a resource to Bank « B »: the liquidity. In parti-
cular, the buyer « B » wishes to rebill the transferor « A »
POST-CRISIS DERIVATIVES VALUATION
ACT III: FUNDING VALUATION ADJUSTMENT

1.2 STUDY OF A SWAP RECOGNIZED AS A LIABILITY

Let us now study the transfer of a swap recognized as a Seen from “A”, the swap recognized as a liability is re-
liability (receiving the cash today and, according to the placed by a debt, this transaction will be associated with
current expectations giving it back in the future): the liqui- a P&L impact if the market derivatives funding spread is
dity is perceived at the transfer date and will be reimbur- not aligned with the classic funding spread of “A”. This is
sed to “C” over the swap lifetime. explained by the fact that these two liabilities, even though
“theoretically analogous”, are not traded in the same mar-
« A » brings liquidity to « B » in this transaction; it is kets: vanilla debt market vs. non collateralized derivatives
natural then that « B » remunerates« A » according to market.
its derivatives funding cost. Depending on whether the
participants agree that « B », the participant representing In case these spreads are equal, the null P&L impact
the market, has a short-term or long-term funding cost, of this liability replacement does not mean that no FVA
the impact will be determined on the basis of a zero or 25 exists. It means that once the FVA impact is registered,
bps spread. similar transactions do not have a P&L impact.

It is interesting to point out that in both cases (asset vs. liability), the potential impact of the FVA is
strongly related to the time horizon that the participants in the transaction agree to assign to the
exchanged liquidity (called derivatives funding spread):

> If the derivatives activities of (both) the Banks are considered as short-term activities and the
liquidity is charged by the treasuries of these Banks, on the basis of a short-term horizon (accor-
ding to our assumptions, the EURIBOR 3M can be taken as the reference in this case), then the
liquidity costs are properly taken into account with the current derivatives valuation framework. No
FVA should be recognized.

> However, if it turns out that the liquidity is backed by long(er) term funding (and therefore more
expensive than short term liquidity), then this extra cost will lead to a discount rate higher than
the one obtained using EURIBOR 3M. In the transfer transaction, the entity that perceives liquidity
would be inclined to grant a discount on the cash payment. The theoretical impact of the FVA is a
reduction in the value of both assets (negative impact) and liabilities (positive impact).

In other words, the derivatives funding spread over EURIBOR 3M is not necessarily not-null and
aligned with the classic funding spread. In particular, transactions and market practice should also
be considered.
 POST-CRISIS DERIVATIVES VALUATION
ACT III: FUNDING VALUATION ADJUSTMENT

2. THE REQUIREMENTS OF THE NORM WITH RESPECT TO THIS

SUBJECT
As a first analysis, and wit-
hout foreseeing normative
documentation of individual
institutions, it should be
noted that the following
features are present in
IFRS 131.

Let’s study the

consequences of IFRS
13.42 on the transfer price
of a liability as studied in
Section 1.2.

To determine the fair value

mance of the Bank « A », considered unchanged during
under IFRS 13, in the case of an entity backing its deriva-
the transaction (a direct result of IFRS 13.42).
tives to long-term funding, we should not consider the 25
bps of Bank « B » representing the market participants,
• 5 bps: component « Base » does not match the risk of
but:
non-execution of Bank « B »;
• 90 bps: spread corresponding the risk of non-perfor-
The funding spread required by IFRS is – based on our
1 The excerpts quoted below can be found at the following interpretation - 95bp for a liability and 25 bps for an asset
address : http://eur-lex.europa.eu/legal-content/FR/TXT/PDF/?u (which is not affected by the provisions of IFRS 13.42).
ri=CELEX:32012R1255&rid=3

Given our interpretation of these articles, the

considered cost of financing must:

> Be based on the observation of transactions

between market participants, to determine if
the cost of funding is short-term or long-term.
Although in theory these costs correspond to fun-
ding for which the maturity horizon is related to
the maturity of the derivative. If the transactions
are done without considering spreads, or with ta-
king into account a projected horizon shorter than
the maturity of the derivatives, then the observed
transactions will be preferred over the theory; and

> For liabilities, include the risk of non-perfor-

mance, specific to the entity and determined
consistently with the horizon of funding determi-
ned above.
POST-CRISIS DERIVATIVES VALUATION
ACT III: FUNDING VALUATION ADJUSTMENT

3. PROPOSITION OF A METHODOLOGY
In this section, we aim to give an economic illustration of 3.2 LIABILITIES FVA
the impacts related to the FVA implementation within a
coherent valuation framework. As mentioned previously, the liabilities spread used
should be adjusted, if necessary, so that the credit risk
3.1 ASSETS FVA corresponds to that of the institution preparing its finan-
cial statements. For instance, one way to proceed is:
The assets FVA corresponds to the valuation difference
between the liquidity costs currently considered (EURIBOR SpreadFVA_Liab = funding_spreadmarket – credit_spread
3M) and the average funding costs for a market partici- market + credit_spreadentity
pant (EURIBOR 3M +spreadmarket). = credit_spreadentity + base(CDS/Bond)market

We do not predict the exact nature of this spread, espe-

cially in terms of its maturity (if the market funds these Numerical implementation:
activities in a short-term perspective then the reference
EURIBOR 3M is still valid and the spread is null, based on SpreadFVA_Liab = funding_spreadmarket – credit_
our assumptions). As seen previously, under IFRS 13, this spread market + credit_spreadentity
spread is ideally observed when transferring derivatives
between market participants. = 25bp – 20bp + 90b

These costs concern the expected assets, this concept is = credit_spreadentity + base(CDS/Bond)market
very close to that of the base used for the CVA: the EPE
(Expected Positive Exposure) component. = 90bp + 5bp = 95bp
To estimate the costs of a period with a horizon “t” and
duration of 1 year, we can initially approach this cost with:

Assets_FVA__approx_1(t) = -funding_spreadmarket x
EPE(t) x 1yr As in the case with the assets FVA for which the base
= -(credit_spreadmarket + basemarket )x EPE(t) x 1yr is close to the CVA, the base to which the liabilities FVA
applies is analogous to that used for the calculation of the
DVA (the aggregation levels to be used for calculating the
Numerical implementation: ENE: the position, the counterparty or all positions, should
be studied).
if Bank « B » represents the market participant
and Bank « A » determines the IFRS 13 fair value However, as for this base, the credit spread of the entity
of the active swap, the spread of the assets FVA has already been recorded in the DVA, and must only
is : 20 bps + 5 bps = 25bps. consider the component (CDS/bond)market.

Liab_FVA_approx = -base(CDS/Bonds)market x ENEmodified

It is interesting to note that this new component concerns by CVA (t) x 1yr
a base analogous to that of the CVA. It is therefore inte-
resting to investigate the related redundancies and the
potential double-counting. These items are of course intended to present the econo-
mic basis of the problem and institutions might rigorously
With reference to the box above : valuation incoherence study the related modelling of the different components of
(IFRS 13) between cash instruments and derivatives for the valuation (CVA, OIS, DVA, FVA…).
the retreatment methodological proposal.

The costs of the future periods should be of course sum-

med up to obtain the total cost.
 POST-CRISIS DERIVATIVES VALUATION
ACT III: FUNDING VALUATION ADJUSTMENT

VALUATION INCOHERENCE (IFRS 13) BETWEEN CASH INSTRUMENTS AND

DERIVATIVES
The proposed methodology does not seem to be In the case of a fair value option debt, the spread base
consistent with the way instruments other than deriva- that would have been considered would have been an
tives are valued: entity own base: if the debt is quoted, the funding spread
that will be considered will consist of an entity own credit
For a derivative recognized as an asset: component, as well as an entity specific base. This incon-
Similar to a security issued by the derivative counterparty, sistency comes from the theoretical exercise requested by
we saw that -in sum- recorded: the formulation of Articles 24 and 42;
• the credit spread of the counterparty via the CVA; and • in the case of a liability, the fair value should consider
• the market funding spread consisting of both the mar- all the entity specific components: the non-performance
ket credit spread and the market base. risk and the other risks; and
• in the case of valuing a derivative recognized as a
We note in particular that two credit spreads are involved liability, Article 24 requires that the funding cost is calcu-
(the spread of the entity funding itself in the FVA and the lated based on the market conditions and that the non-
spread of the counterparty in the CVA), whereas in the performance risk is entity specific. Funding components,
valuation of a security issued by the counterparty of the other than credit spread, are hence not entity specific.
derivative, only one credit spread is involved (the return
on the issued liability).

Based on the article «The black art of FVA, Part II: Condi-
tioning chaos» written by Matt Cameron Risk.net, Obbe
Kok of ING asserts that there is double-counting of coun-
terparty risk. According to him, a Bank’s creditors demand
a particular remuneration for the counterparty risk that
the Bank undergoes. CVA and financing costs would result
in a single risk that the Bank would transfer through from
the counterparty to creditors. If recorded in the CVA for a
second time, this item would be redundant.

The reality seems more nuanced as investors take into

consideration elements other than the nature of the coun-
terparties to determine the Bank’s financing cost: market
risk taken by the Bank, legal risk of past activities and
other potential risks related to activities other than deriva-
tives, are examples of such considerations. However, a
possible retreatment of a part of the credit risk common
to counterparties (CVA) and Banks (FVA) could be consi-
dered by some institutions in order to reflect in valuations
the double-counting, as mentioned by ING. A possible split
of the spread into systemic, sectorial and specific compo-
nents could be considered in order to identify the part of
the spread already booked in CVA. Observed transactions
would again be decisive.

For a derivative recognized as a liability:

Similarly to a security issued by the Bank preparing its
financial statements, we saw that –in sum- recorded;
• the own credit spread via the DVA; and
• the base credit spread / funding spread of the market.
OPERATIONAL DIFFICULTIES: OBSERVING TRANSACTIONS AND FUNDING
HORIZONS
In the introduction to this article it was pointed out that
the valuation was closely linked to the practices adopted
by various market participants, in terms of the funding of
“IT IS NOT OBVIOUS THAT A
these positions. In particular, it was mentioned that if all DERIVATIVE GENERATING POTENTIAL
the Banks were funding (or were billing as such) these
short positions so there was no need to consider FVA, FUNDING DEMANDS OF 5 YEARS MUST
EURIBOR 3M reference would have relevant.
NECESSARILY BE FUNDED AT THE 5 YEAR
Due to the several positions of Banks (particularly JP
Morgan), it seems that this situation is no longer up to HORIZON.”
date. In these conditions, it is not obvious that a derivative
generating potential funding demands of 5 years must Therefore, it is possible that the practitioners would
necessarily be funded at the 5 year horizon. withhold more long-term intermediary funding horizons,
more expensive than EURIBOR 3M, without exposure
The first reason is that this would require Banks to regu- horizons that coincide with EPE and ENE. It is hence
larly invest / redeem long-term resources depending on preferable for the emergence of a clear consensus that
the evolution of the market and on their own potential institutions communicate more about the spread level
evolution. being used.

CONTACTS
Mazars
61 rue Henri Regnault
92075 Paris-La défense France
Tel. +33 (0)1 49 97 60 00

Emmanuel Dooseman
Partner, Global Head of Banking
E-mail: [email protected]

Nordine Choukar
Partner, Head of Financial Quantitative Services
E-mail : [email protected]

Christophe Bonnefoy
Senior Manager, Quantitative Analyst & Actuary Detailed information available
E-mail: [email protected] on www.mazars.com