Financial year end is fast approaching
and many end users of Derivatives still grappling with issues of component of
Fair Value for a Derivative on their Balance sheet. Many of you are Corporate Treasurers,
Auditors or valuation personnel at financial institutions who are asking
questions like why OIS discounting, CSA discounting, should I need to apply CVA
and DVA, am I being charged for FVA etc. Debate around some of these like what
discounting approach, (OIS vs Libor) has been settled in terms of calculating
the discount curves and methodologies. Items like FVA have been the hot topic
for last few months. In this article, we show general characteristics and
context around these issues.
An evolving environment
The global financial crisis ushered in
a new era of increased regulatory scrutiny. In this new environment, regulators
have, and continue to implement a host of new laws and rules to prevent a
repeat of the crisis. Implementation of regulations namely, the Dodd-Frank Act,
Basel III framework constraining financial institutions in their strategic
choices by increasing capital and liquidity requirements and will face higher
costs in providing financial products to their consumers. During the period of credit expansion that
preceded the financial crisis corporate consumers were able to expand
activities on the wave of cheaper credit extended by banks due to under pricing
of liquidity and funding costs. Banks were universally pricing financial instruments
like derivatives by discounting future cash flows at LIBOR. If these cash flows
are not risk free then they will be adjusted by CVA. Financial crisis has
illustrated that OIS rate (which
is weighted average of overnight unsecured lending rates in US interbank
market) not LIBOR is risk free rate due to
embedded credit risk. Also, banks cannot possibly borrow and lend at LIBOR due
to funding risk. Now derivative pricing is undergoing revolutionary changes.
Credit and liquidity risks those were negligible in pre-crisis period were
addressed by including, credit risk, collateral and funding to measure fair
value of an instrument. Having set this context, as a user of financial
instrument you need to understand how valuation has changed from the world of
simple LIBOR discounting to a new world of OIS discounting with various
valuation adjustments. This understanding is imperative to know cost drivers of
the value of a derivative product and helps you to make an informative decision
in transacting them.
Changing the way you do
business
Derivative
valuation primarily comprises of forecasting cash flows and then discounting
these cash flows to current day and applying various valuation adjustments.
Anatomy of Fair Market Value
Risk Free Value: Fair market Value of a derivative
using risk free rate
CVA:
Credit Valuation adjustment is adjusting the fair value due to loss arising
from the default risk of the counterparty
DVA: Debit Valuation adjustment is adjusting the
fair value due to loss arising from the own default risk of the entity
FVA: Funding Valuation adjustment to fair value
to account for funding costs
Coll Va:
Adjustment to fair value to account for difference in the value of derivative
in risk free rate discounting vs actual CSA discounting
Risk Free Value:
Before the 2007 dealers, as well as
their regulators and auditors viewed fixed rates on LIBOR swaps to be a
reasonable and workable proxy for the risk free yield curve and this task was
quite simple. For a LIBOR based interest rate swap cash flows are projected and
discounted using a LIBOR curve. 2008 financial crisis has illustrated the
credit risk in LIBOR curve clearly and replaced it with OIS rate. OIS rate is
Fed funds rate which is weighted average of overnight unsecured lending rates
in US interbank market. This rate due to overnight tenor carries least amount
of credit risk. At the peak of crisis OIS-Libor swap spreads widened from 5-7
bps in pre-crisis period to 350bps. Typically, for a collateralized derivative
with daily margining OIS rate is specified in CSA (credit support Annexe).
Hence OIS rate with its least embedded credit risk and underlying funding rate
for collateralized derivatives is suitable rate for risk free valuation.
Within OIS discounting valuation framework, cash flows are projected using
Libor curve and discounted using OIS curve to calculate risk free value. Once
risk free value is determined, banks add the cost of counterparty credit risk
to adjust the value of the trade if cash flows are not risk free by adding credit
valuation adjustment (CVA). Hence a high risk corporate will have to pay higher
cost for entering into trade with an institution compared to low risk
counterparty. In a world where all
counterparties use CVA will never agree on one price for a trade. Debit
valuation adjustment (DVA) took it genesis from considering bilateral CVA
(BCVA). Therefore Risk free value is adjusted for default risk arising from the
institution (DVA) and their counterparty (CVA) and accounting for credit risks
in the valuations that were not considered in pre-crisis period.
Funding Valuation
Adjustment
Corporations and other non financial
entities use derivatives to manage their cash flow operations and they do not
post daily collateral and hence called Uncollateralized Derivatives. Banks aim
to run hedged books therefore hedge these uncollateralized derivatives with
collateralized trades face collateral and funding costs. Institutions
are accounting for collateral and funding costs via funding valuation
adjustments to the risk free value.
Bank
A simultaneously enters into an offsetting hedge swap with another Bank B. Bank
A has to post and receive collateral on this hedge swap whenever the hedge swap
has negative market value and positive market value respectively.
Negative Market Value:
When hedge swap has negative market value client swap will have positive market
value. Bank A has to post collateral. In this case bank borrows funds at banks
unsecured borrowing rate and posts collateral that is earning OIS rate.
Positive Market Value: When
hedge swap has positive market value client swap will have negative market
value. Bank A receives collateral that is earning OIS rate.
Bank
A is in a situation where it has to borrow funds at its funding rate to post
collateral. At the same time collateral earns OIS rate creating an asymmetric
situation. Due to this Bank A has to adjust the market value of the swap with
funding valuation adjustments (FVA). FVA
accomplishes the goal of adjusting the funding costs that are not accounted by
OIS valuation.
Conclusion: Derivative
products that are collateralized should be
1) Discounted by
appropriate collateral yield curve
2) Apply CVA and
DVA to measure and adjust its Value
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