Valuing Derivatives: Funding Value Adjustments and Fair Value

by John Hull of University of Toronto, and
Alan White of University of Toronto

September 16. 2013

Abstract: The treasury desk of a bank typically charges the derivatives desk for the funds it uses at the bank's average funding cost. This has led some derivatives desks to include a funding value adjustment (FVA) in their pricing models for non-collateralized transactions. This paper examines this practice. It explores the relationship between FVA and other pricing adjustments and argues that it is a mistake for a bank to incorporate FVA in its pricing. It shows that FVA is liable to lead to conflicts between traders and accountants. If it incorporates FVA in its pricing, the types of transaction a bank enters into with end users will depend on how high its funding costs are. Furthermore, FVA gives end users arbitrage opportunities.

JEL Classification: G13, G21.

AMS Classification: 91B28.

Keywords: Derivatives, Fair Value, FVA.

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