Post-crisis derivatives valuation act III : Funding valuation adjustment
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.
Initially, this has been particularly reflected by the Credit Valuation Adjustment (CVA) and the Debit / Debt Valuation Adjustment (DVA) that account for the credit risks to which each counterparty are exposed.
Secondly, the rates used to discount the cash flows of the collateralized derivatives have been defined in accordance with the rates used to value the exchanged collateral, usually the OIS.
The actual problem
While institutions are continuing to enhance their estimation of the above elements, a consensus seems to be emerging on how the cash flows of the non-collateralized derivatives are to be discounted. Discounting assuming a short-term financing of these positions (EURIBOR 3M rates were used as reference) has been abandoned by institutions that observe that the prices of derivatives transactions appear to incorporate more long-term liquidity risks.
In this article, we first propose to illustrate this problem by bringing out the reasons why these costs might have to be taken into account; secondly, we study the normative requirements governing the determination of the discount rate; and finally, we propose a methodological approach.