FVA Calculation and Management
CVA, DVA, FVA and their interaction (Part II)
This is the second part of a dual paper on FVA. It explains how to calculate FVA and how to manage funding risk.
The calculation and management of funding risk for a portfolio of OTC derivatives is anything but trivial. In the first part of this paper (FVA Demystified), we discussed the ideas underlying FVA. We saw that it is an adjustment made to the price of a portfolio of derivatives to account for the future funding cost an institution might face. We also saw that it is very important to differentiate between the Price of a derivative (the amount of money we would get if we sell the derivative) and the Value to Me (the Price minus my cost of manufacturing the derivative). In this paper, we are going to investigate the practicalities of FVA. We will see how FVA can be calculated and managed. If we have a proper CVA system, calculating FVA is not too difficult, subject to a few reasonable assumptions. This can be achieved because a good CVA Monte Carlo simulation already calculates many of the inputs needed to compute FVA. Also, we will explain the role of FVA desks in current large organisations, as well as how FVA can be risk-managed and hedged. Finally, we propose a management set up for CVA and FVA, and understand why a number of institutions have decided to join both desks.