1. FVA - Putting funding into the equation
3rd Marcus Evans Derivatives Funding Valuation conference
September 2013

2. Contents I
Background II
FVA Calculation
III
Operating Model

3. FVA – Funding Valuation Adjustment
Background What is FVA?
FVA – Funding Valuation Adjustment
Funding-Spreads widened
Consideration of funding cost in pricing and valuation is highly relevant since the crisis in 2007/2008
The introduction of OIS Discounting was a first step to consider funding cost in valuation for the collateralized derivatives business
FVA is the next step on our way to fully consider funding cost in pricing and valuation. Basically it deals with the consideration of funding cost of uncollateralized derivatives.
In the market practitioners currently develop conceptual FVA calculation approaches and first start implementation
New concepts for valuation

4. Background FVA in the press
Hull and White debate
Goldman story
Regulation
Banks at risk of FVA arbitrage
Unfair value: FVA's hidden charms
Goldman and the OIS gold rush: How fortunes were made from a discounting change

5. Background Discounting Collateralized Derivatives
Fixed at 5% v market level of 2%
Bank A
Bank B
PV: €+10m
IRS
PV €-10m
3M LIBOR
PV: €-10m
Cash Collateral
PV: €+10m
EONIA on Collateral
Assume that for counterparty A the PV(A) is positive (e.g. €+10m).
The collateral account holds the total PV of the swap (bank A: €+10m, bank B: €-10m )
The collateral amount is available to bank A. On return, bank B receives the overnight rate on the collateral amount from bank A.
Consequently, the collateral mechanism can be interpreted as a funding mechanism at overnight rate, transferring liquidity from bank B to the bank A.
Notice that as PV(A) is positive, (under assumptions of the example) bank A has paid a net cash amount to bank B since the inception of the swap. This suggests that bank A has in fact a funding demand.
By no-arbitrage arguments, the CSA collateral rate and the discounting rate of future cash flows must match (hard mathematics!)
Discounting of collateralized derivatives with the collateral rate (OIS)

6. Background Discounting Uncollateralized Derivatives
An uncollateralized swap has no implicit collateral funding mechanism
The funding cost of an uncollateralized swap are therefore the bank’s individual funding cost (e.g. LIBOR bp)
The price of an uncollateralized deal is related to the cost of funding
There is currently no clear market view on valuation methodology and/or how the cost of funding is actually determined. Most practitioners agree that own funding cost need to be considered.
Risk of double counting effects between CVA, DVA and own funding cost / FVA
Fixed at 5% v market level of 2%
Bank A
Client
IRS / client derivative
PV: €+10m
PV: € -10m
3M LIBOR
3M LIBOR
+ 50 bp
Notional
(€ 10m)
Funding
Capital Markets / Investors

7. Mirroring Client derivative?
Background Funding effect from derivative transactions cannot be estimated by collateral position
Typical situation: Uncollateralized client trade, hedged back-to-back with a CSA counterparty – one-time change in market interest rates
PV of uncollateralized client derivate assumed to have become large and positive (from bank’s perspective)
No collateral received, no influence on cash position
Future positive net product cash flows will be received from client
PV of hedge derivative is negative
Collateral amount equal to hedge PV has been transferred to hedge counterparty. Negative cash position
Collateral earns OIS (EONIA) interest
All future product cash flows will be neutralised by collateral paid back (and vice-versa)
Net effect: positive PV needs to be funded until realization by uncollateralized product cash flows
Client
Uncollateralized Derivative
Client Business
Bank
BU/Desk
Treasury
Funding
Collateralized Derivative
Hedge trade
Mirroring Client derivative?
Hedge Counterparty
Important:
The hedge in general does not involve same fixed rate coupons (re-couponing macro hedge)
This means the collateral position in general is not useful as an estimator of FVA - only uncollateralized trades must be considered

8. Background Advancements in derivates valuation: CVA, DVA, Funding
Since 2000: Consideration of counterparty credit risk in derivatives valuation
Consideration via CVA (Counterparty Credit Valuation Adjustment)
CVA is market price of counterparty credit risk / cost of hedging
Derivates valuation with
Counterparty VA
Derivates valuation without
Counterparty VA
CVA = +
Introduction of bilateral CVA
Consideration of market price of own default risk via DVA (Debit Value Adjustment)
Derivates valuation with
Counterparty VA
Derivates valuation without
Counterparty VA
CVA
DVA = + +
Since 2007/2008: Rise in bank funding cost and introduction of funding in valuation
Consideration of funding cost/benefit in derivatives valuation applying a FVA (Funding Valuation Adjustment)
Derivates valuation with
Counterparty VA and Funding VA
Derivates valuation without
Counterparty VA and Funding VA
CVA
DVA
FVA = + + +
Double Counting Issue

9. Partially collateralized
Background Landscape of collateralized and uncollateralized derivatives business
Fully collateralized
Partially collateralized
Uncollateralized
Assumption of “perfect” CSA, i.e. bilateral CSA, no thresholds
Future product cash flows are fully funded / invested by the collateral received / posted
External interest on collateral defined by CSA-rate, e.g. EONIA
Unilateral CSAs, thresholds and/or minimum transfer amounts
Product and collateral cash flows do not match
No CSA
Future product cash flows need to be funded / invested
Market practice for valuation Closed formula: discounting on CSA/OIS- curve already implemented by most institutions
No generally agreed market practice yet Heated discussion between practitioners and in academia
Focus of this talk
Open issues
How to handle initial margins / independent amounts and/or a liquidity reserve held to cover future market value or resp. collateral volatility?
Open issues
Consistent internal pricing framework: Link to accounting, Link to funds transfer pricing
FVA, CVA and DVA - how to avoid double counting?
FVA is relevant for all kinds of derivatives

10. Contents I
Background II
FVA Calculation
III
Operating Model

11. Putting funding into the equation: KPMG’s view on FVA
General principles for FVA calculation
Proposition 1
Proposition 2
Proposition 3
Proposition 4
Proposition 5
Valuation models need to take into account all cash flows associated with a derivative - including collateral flows and funding cost and benefits
Assumptions concerning effective life times of uncollateralised derivatives positions will influence FVA
From a bank management perspective a close alignment between the rules for FVA calculation and the bank’s funds transfer pricing rules would be desirable
Despite the bank- specific nature of FVA calculated using a bank’s own funding curve this can often still be justified as a reasonable estimate of funding cost and benefits in IFRS fair value calculations
In general FVA needs to be determined on a portfolio level with subsequent allocation to individual trades
Differences between FVA and DVA and their consolidation
(Active) management and governance
Proposition 6
Proposition 7
Proposition 8
Proposition 9
FVA has potential overlaps with both CVA and DVA that need to be taken care of in a consistent pricing/valuation framework
One way to avoid double counting between FVA on the one hand side and CVA/DVA on the other is to take one as the increment to the other.
Whilst DVA is an accounting requirement it should not be considered in managing the business
There are advantages to managing FVA centrally, and close alignment to the CVA desk can be efficient

12. Transparency in funding cost will lead to re-couponing
Proposed FVA framework (proposition 2) Close alignment between funds transfer pricing and FVA means application of a real funding curve in a two way market
Central counterparty
Standard CSA
Restructuring
Transparency in funding cost will lead to re-couponing
Decrease in uncollateralized trading volume
Re-negotiation of non-standard CSAs already ongoing

13. Proposed FVA framework (proposition 3) Close alignment between funds transfer pricing and FVA means application of a real funding curve in a two way market
Consider liquidity cost and benefit
It is not only fair but necessary to charge for liquidity need and to compensate liquidity benefits.
As valuation and pricing should be consistent with internal incentives cost and benefit must both be part of FVA
Price cost and benefit on bank’s own (internal) funding curve
For risk management reasons and for internal transfer reasons the bank‘s own funding curve (which is in general not the bank‘s senior unscured curve) must be applied
Only under application of the bank‘s own funding curve an internal transfer of liquidity term risk towards treasury is fairly priced internally
Divide between term funding and liquidity buffer component
As the term funding component should be transferred to treasury to allow netting with other positions in the bank and to enable central management the buffer cost are a different „beast“

14. Funding/ Investment of derivative and collateral CFs
Proposed FVA framework (proposition 3) Bank management profits from consistency between FVA and internal liquidity transfer pricing (FTP)
Core elements of FTP
Implications for FVA
Liquidity is managed by a restricted set of capital markets transactions (term funding, asset investment, ...)
Internally liquidity is transferred between businesses at one price (FTP)
Any liquidity (spread) risk is transferred to a central Treasury function
To avoid arbitrage, liquidity from trading activities need to be priced similar to other business areas (e.g. credit business)
Therefore, the FVA calculation needs to be aligned with concepts of FTP
This leads to a number of benefits, e.g.:
Avoiding the large bid/ask spread currently observed in the capital market by netting on bank or even group level
No arbitrage between different businesses
Clear rules on handling liquidity in foreign currencies
Clear rules on allocation of the cost of liquidity buffers
Basis for FVA
Business Unit
Treasury
Term funding
Markets
Funding/ Investment of derivative and collateral CFs
Investment
Liquidity transfer
Other BUs
FTP
FTP

15. Proposed FVA framework (proposition 5) Generally FVA is calculated on portfolio level and not on single transaction level
Portfolio-view
Calculation of the expected or relatively sure liquidity position to determine the term funding component
Calculation of unsure liquidity streams for liquidity risk control, if neccessary buffer
Consideration of portfolio effects as, for example, non-standard-CSAs, e.g.
Onesided CSAs, high minimum transfer amounts and threshold amounts
Partial collateralization of the portfolio with assets of different quality
Modelling of expected product life time taking into account future restructurings, break clauses and trends as for example central counterparty trading
FVA is a valuation component with significant risks of higher order (cross gamma), analytics and risk control similar to CVA
Distinction between deterministic and volatile funding effects
Consideration of CSAs
Assumptions on the life time of the portfolio or product
Cash Flow / Liquidity profile +
Risks of higher order (e.g. cross gamma)
Contractual CF  
Modelled CF
time -

16. Proposed FVA framework (Proposition 6) Double counting of FVA and DVA is somewhat obvious but also CVA needs to be considered
Assume that a bank will receive “N“ at time “T“. The bank prices this under consideration of counterparty credit risk / CVA and FVA
Position causes funding need and bears credit risk
Interest rate
FVA*
CVA
Look at a degenerated balance sheet
Balance Sheet
Assets Liabilities
Funding cost depends on the banks asset quality. This means that CVA and DVA and FVA have joint risk drivers. Simply summing up the effects leads to double counting.
Loan position
Credit Risk
Funding Position
Spread driven by asset’s credit risk
*Simple term funding FVA

17. Not considered in this schematic diagram
Proposed FVA framework (proposition 7) Double counting can be avoided by defining and calculating FVA, CVA and DVA as mutual increments
FVA
Positive and negative funding effects must be netted => FVA is based on net expected flows/exposure
EE x fs
Not considered in this schematic diagram
CVA
DVA
EPE x ccs
ENE x ocs
Funding = FVA + liquidity buffer
ENE and EPE add up to EE
Replication does not result in the sum of liquidity and credit premium*
We find it most practical to define CVA and DVA as increments of the (symmetric) FVA
* E.g. a funding ticket is not traded by the price of funding cost + DVA
FVA
FVA on the basis of EE and funding spread “fs“
EE x fs
CVA on the basis of EPE and residual credit spread “ccs -fs“
CVA
Funding Spread
DVA
DVA on the basis Basis of ENE and residual credit spread “ocs -fs“
EPE x [ccs-fs]
ENE x [ocs-fs]
Counterparty Credit Spread
Own Credit Spread

18. Transfer scheme is based on established core competences
Proposed solution (proposition 9) A central FVA control is advantageous; the use of the CVA infrastructure may be an efficient way of implementation
Liquidity spread risk
FVA
Trading unit
FVA Management
A/P Mgt.
Treasury
Management of market risks
Gain/cost from the transfer of the FVA
Complex „hybrid“ risk
Risk drivers are liquidity curve and market risk drivers as e.g. interest rates and cross gammas
Quality of the risk position comparable to CVA
Management of the banks liquidity position
Control of the liquidity spread risk
Control of the maturity transformation
Transfer scheme is based on established core competences
Remark
The scheme allows, besides the use of available core competences, also the use of available infrastructure. This may be of help at employing portfolio simulations or scenario engines and the related aggregation tools as well as analytics for the FVA management.

19. Contents I
Background II
FVA Calculation
III
Operating Model

20. Operation Model Is it necessary to establish a FVA desk?
Tasks of the FVA desk
Analytics
FVA calculation
Sensitivities and scenario calculations
Risk Management
Hedging of term funding (spread risk) with treasury
Differentiation between term funded liquidity and liquidity buffer
Consulting
Understanding Cross Gamma risk
Guidance for trade pricing and (spread) risk mitigation in trading
Benefit of FVA desk
Special core competence
Specialized in complex hybrid risk position
Owner of dedicated analytics
Enables active risk management
Takes hedge decisions with deep portfolio insight
Helps trading comply with liquidity (spread) risk limits in an optimal way

21. Operation Model What are the key tasks and competencies of a FVA desk?
FVA „cost/benefit“
Liquidity spread risk
Trading unit
FVA Management
A/P Mgt.
Treasury
Liquidity buffer cost
Derivatives trading in the market
No market access
Hedging via internal funding tickets
Decision on hedge strategies term hedge / buffer
Consulting role for trading and treasury
Limit management for buffer funding of FVA desk to make sure treasury leads the term transformation
Market access to secured and unsecured funding
FVA desk is not a liquidity trader but transforms the liquidity position into term funding an liquidity buffer cost and transfers it to treasury

22. Market Risk Management Mobile +49 172 3006809 matthiaspeter@kpmg.com
Partner
Market Risk Management
Mobile
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