Should Derivatives Dealers Make A Funding Value Adjustment?

John Hull and Alan White

Many derivatives dealers believe that they should incorporate their funding costs into the determination of the fair value of derivatives. The resulting change in the value of the derivative is known as a funding value adjustment (FVA). In this chapter we shall present a sequence of arguments to show that a funding value adjustment should not be made. The value of a derivatives transaction, or portfolio of derivatives transactions, does depend on the credit risk of the two sides, but it should not depend on the funding costs of either side.

Hull and White (2012c,d) presented economic arguments that show that the adjustment should not be made. But, in practice, many dealers find these arguments unconvincing and choose to make the adjustment anyway (see, for example, Ernst & Young 2012). In this chapter we rely on arguments that are closer to the operations of the trading desk.

The theoretical valuation of a derivative nearly always involves an application of risk-neutral valuation. In this, expected cashflows are estimated in a risk-neutral world and discounted using a “risk-free” interest rate. The interest rate serves two purposes. It is used as the discount rate and it