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'xVAs' have found their way in to pricing and valuation

A common theme emerged on the first day at the Global Derivatives Trading and Risk Management Conference. CVA, DVA and FVA (but also a number of other components) have found their way into pricing and valuation models of financial institutions after the financial crisis of 2008.

After a macro-economic assessment by David Nowakowski of Roubini Global Econmics, which drew a somewhat grim picture with especially China being in slow-down, famed John Hull took up the stage to speak about the implications of the Funding Value Adjustment (FVA).

FVA can be defined as the difference between valuing a portfolio of uncollateralized transactions using the assumed "risk-free" rate (which is typically the OIS rate or LIBOR) and valuing it using the bank's actual (!)average funding cost.

Hull made it clear that the theoretical funding of a bank will mostly be divergent from the actual funding requirement. This makes it quite difficult for banks to incorporate FVA into their pricing and still find a common ground with their counterparty to actually close the deal.

In the following panel discussion JesperAndreasen, Global Head of Quantiative Research at Danske Bank and two-time Quant of the Year, stated the financial crisis has propelled financial institutions to incorporate credit and funding risk into their pricing and valuations models.

Andrew Green from Lloyds Banking Group then gave a detailed introduction into the new pricing paradigm after the crisis and the new components that flow into pricing compared to before the crisis.

It shows the rising complexity of but also interdependence between pricing components. Subsequent presenters, who were delving deep into the construction of applicable models and their various components, proved this as models and even the derivation of model components has grown more and more complex over recent years.

The role of the quant will grow more important to financial institutions trading derivatives to ensure that pricing and subsequent valuation will be nearer to the truth. But we should not forget two things.

Firstly, all modelling will always be an approximation of the reality. As such, it seems sensible for market participants to find equilibrium of ever-more detailed models verses the effort one has to invest into creating them.

And secondly, and in my mind more importantly, smaller buy-side clients need to be taken on an educational journey to give them the ability to understand the more complex math behind today’s derivatives pricing. This would go a long way to foster and maintain good client relationships.

Original story on: http://theotcspace.com/2013/04/17/xvas-have-found-their-way-in-to-pricing-and-valuation/

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