WOE is XVA?
If you’re wondering what the title means, it stands for “What on Earth is X Valuation Adjustments”? This month Colin Sharpe from NAB presented to the technical committee on the rapidly changing world of derivative valuations and pricing. The reason for the “X” in XVA, is because there are now so many valuation adjustments for uncollateralised derivative transactions, that the acronym simply has an X as a placeholder for the numerous adjustments that are now applied by banks when pricing derivatives.
Pre-GFC, life was simple. Derivatives were simply valued using a bank swap curve (BBSW etc), and that was that. Banks have always priced for credit and for profit (shock horror!) among other things so in reality CVA (or credit valuation adjustment) has always been around, however it became more widely known throughout the corporate treasury world with the onset of the GFC when both corporate and bank defaults became a reality and CVA became more material. The introduction of IFRS 13 Fair value then codified the need to apply CVA and DVA. If any Corporate treasurer remembers having derivative positions with Lehmann Brothers they will know all about bank default risk and why CVA matters.
Since then, banks have realised that there are numerous other costs which are common to all derivative dealers, and that should be adjusted for and priced in when transacting derivatives which are not collateralised (which is typically the case with corporate end-users of derivatives.)
The most common adjustments are CVA/DVA (adjusting for the risk of default of both counterparties, and the cost of hedging default risk), funding valuation adjustment or FVA (the funding cost or benefit resulting from banks posting/receiving collateral on their inter-bank hedge trade, but not receiving any collateral on the end-user derivative trade), and now KVA (the cost of regulatory capital for the bank through the transaction life).
This is quite a complex area which not only affects derivative pricing, but also impacts the valuations and accounting on the banks side, as well as causing differences between corporate valuations and bank valuations. This topic will be explored in much more detail at the FTA Annual Conference.
If you would like further information about this topic, please contact the FTA.
Steven Cunico FFTP