XVAs and the Holistic Management of Financial Resources

Massimo Baldi, Francesco Fede and Andrea Prampolini

Faced with the seemingly unending spawning of XVAs – the valuation adjustments to the fair value of derivatives – since the 2007–9 financial crisis, anyone who used to trade interest rate derivatives prior to the crisis could be forgiven for thinking, as William of Occam allegedly said, entia non sunt multiplicanda praeter necessitatem, ie, entities should not be multiplied without necessity. Those were the days when a swap was a swap and you knew what you were trading. Then came the realisation that a swap was actually the carrier of multiple diseases, hidden in the small print of the contracts, and the world has not been the same since.

In the aftermath of the crisis, market players had to come to terms with the reality of so-called “second-order” risks, in particular counterparty risk and funding risk, impinging on their positions. As their counterparties could no longer be counted on to honour their commitments, and as liquidity became a scarce and costly resource, banks had to go through their derivatives portfolios thoroughly and identify all the asymmetries in what looked like matched books from a market risk perspective. First, the banks had to tell apart collateralised