Derivatives and Funding Value Adjustments: A Simple Corporate Finance Approach
52 Pages Posted: 3 Aug 2017
Date Written: December 15, 2016
In the aftermath of the GFC, banks have adjusted their books of derivatives for funding costs and have made Funding Valuation Adjustments (FVA). These adjustments are surprising for two reasons. First, they are made on a voluntary basis. They are neither imposed by banking regulation nor suggested by accounting guidelines. Second, there are controversial within the academic community. The issue of whether the valuation of derivatives should account for funding costs has been highly debated in the recent years and remains unsettled. The goal of paper is to suggest a simple corporate finance approach to assess and illustrate the impact of funding costs on the valuation of derivatives and on the value of a dealer bank. In line with the conclusions of Hull and White (2012, 2014) and Andersen, Duffie and Song (2016), among others, it argues that the funding of derivative contracts leaves the bank value unaffected and that derivatives’ valuation should not be adjusted for funding costs or benefits. The paper highlights the issues of wealth transfers between the shareholders and the creditors, and raises the issues of conflicts of interests between derivatives dealers, creditors, and the bank’s shareholders.
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