Funding Value Adjustment (FVA)

Abstract

This paper reviews the concept of fair value adjustments in relation to adjustments that could arise due to counterparty default risk and funding needs. Using a simple economy of a market, a firm and its counterparty, the relationship between the credit value and funding value adjustments of the firm is established. It is shown that the cost of funding from the market does not play any role in the fair valuation of the firm's OTC portfolios. It's main role is to offset the market-facing credit benefit. The credit benefit and the credit charge, that the firm faces its counterparty, will still be the main contributors to the fair value adjustment. Using the allocated cash account which manages the funding of the firm's portfolio with the counterparty, the paper provides a method of calculating the funding cost facing the market. An illustration of a set of four simple scenarios for different cashflow schedules is also provided. The author is seeking feedback. Please contact the author for an updated copy.