Managing Derivative Funding Risk - The FVA Debate An Industry Thought Leadership Forum

Managing Derivative Funding Risk - The FVA Debate Professor Moorad Choudhry – Treasurer, Corporate Banking Division, The Royal Bank of Scotland Alexander Sokol – CEO, CompatibL and Founder, Numerix Etienne Koehler - Head of CVA Risk Modeling, HSBC Robert McWilliam – Managing Director, Global Head of CVA Desk & Collateral, ING Bank

Managing Derivative Funding Risk - The FVA Debate Impact of collateral, CCP and bilateral initial margin Alexander Sokol, Numerix/CompatibL PRMIA London October 31, 2012

“Trading desk” view of FVA ●These slides define FVA narrowly as the expected value of deal costs not already included in MtM and CVA ○The meaning of this definition radically depends on which methodology is accepted by the firm for MtM (OIS or LIBOR discounting) and for CVA (unilateral or bilateral) ●Total economic effect of the deal for the desk is then MtM + CVA + FVA ○In many jurisdictions, only MtM and CVA can be treated as P&L under accounting rules

“Trading desk” view of FVA contd. ●Additional assumptions implicit in this practical definition of FVA ○Hedging with another counterparty is included only to the extent it is already part of the firm’s definition of MtM (e.g. OIS discounting is based on the assumption that the hedge is funded by collateral posted under perfect CSA) ○Any excess funding is provided by the firm’s funding desk

Purpose of this definition ●This definition of FVA tells the desk what the difference is between (a) the total cost of managing the deal through maturity, and (b) the sum of MtM and CVA they can book as P&L according to the firm’s accounting rules ○We do not consider the complex arguments related to shareholder value etc. ○Desk here refers generically to all desks which trade with this counterparty, but not the funding desk or the rest of the firm

Traditional bilateral collateralization ●Under traditional bilateral collateralization (e.g. CSA), counterparties post collateral based on current exposure for each netting set ○Collateral agreement may be unilateral (one party posts collateral) or bilateral (both parties post collateral) ○Collateral is posted on net basis – one party is posting and the other receiving; parties do not hold each other’s collateral ○Collateral is posted for exposures above a threshold

CCP initial margin requirement ●Central clearing reduces credit risk but imposes new funding costs via overcollateralization (initial margin) ○To reduce credit risk, central clearing requires the firm to post more collateral than the exposure to cover for possible sudden exposure increase in a crisis ○The funds for collateral must be borrowed on the open market, but receive lower CSA rate (usually the OIS rate) ○This eliminates CVA but creates FVA cost in its place

BCBS margin proposal (BCBS226) ●Proposal to require margins based on both potential future exposure (initial margin) and current exposure (variation margin) for non-cleared OTC trading ○Initial margin should be exchanged by both parties, without netting of amounts collected by each party (i.e. on a gross basis). Amounts legally segregated or held by custodian. ○Very limited allowance for netting ○Quantitative models or schedule for initial margin; models calibrated to the period of stress to reduce procyclicality

FVA and CSA with thresholds ●CSA or other “less than perfect” agreements include thresholds which reduce the amount of collateral relative to perfect CSA ○Funding cost (benefit) relative to OIS discounted MtM for the side receiving (posting) collateral ○FVA moves the total in the direction from OIS discounted price to unsecured (“LIBOR”) discounted price

FVA and overcollateralization ●CCPs and BCBS 226 proposal require overcollateralization; the amount of collateral exceeds that of perfect CSA ○Excess amount of collateral must be borrowed in the market creating a new funding cost relative to OIS discounted MtM ○This funding cost may exceed the benefit from the elimination of CVA, however CVA impact is part of P&L but FVA is not, creating a large P&L impact immediately due to the different accounting treatment

PRMIA panel discussion Managing Derivative Funding Risk - The FVA Debate 31st October 2012 Etienne Koehler (University of Paris 1 La Sorbonne)

13 Hull and White’s position FVA = interest payments made above the risk free rate interests on the money borrowed to manage a portfolio. 1.Discount must be done at the risk-free rate because it is required by the risk- neutral valuation principle 2.If a dealer takes into account the DVA of the funding strategy, then the FVA disappears, since FVA= DVA of the funding strategy 3.The DVA of the funding strategy is a benefit to shareholders, so it should be taken into account 4.Even if a dealer does not take into account the funding strategy’s DVA, there is no need for an FVA

14 Some industry responses 1.Risk-free rate Why not for the “building block” but one calibrates expressions of the form ZC Bond * expected forward 2.If a dealer takes into account the DVA of the funding strategy, then the FVA disappears, since FVA = DVA of the funding strategy Theoretical computations say yes (e.g., cf. Morini) 3.The DVA of the funding strategy is a benefit to shareholders - At least it shows a better balance sheet, hence better dividends, etc. - What is the point if you have to wait for default to realize DVA? - Buying back your debt probably not realizable more than once 4.Even if a dealer does not take into account the funding strategy’s DVA, there is no need for an FVA Not clear. True in the bilateral case as FVA ≈ 0 Link between hedging and FVA?

15 Disclaimer The views and opinions expressed in this presentation are those of the author alone and do not necessarily reflect the views or policies of HSBC Investment Bank, its subsidiaries or affiliates. HSBC BANK PLC REGULATED BY FSA REGISTERED IN ENGLAND NO REGISTERED OFFICE: 8 CANADA SQUARE, LONDON, E14 5HQ, UNITED KINGDOM MEMBER HSBC GROUP

This event was kindly sponsored by