CVA, DVA, FVA and their interaction (Part I)
This is the first part of a dual paper on FVA. This one offers a review of the concept behind FVA, and how it interacts with CVA and DVA.
There is currently a rather heated discussion about the role of Funding Value Adjustment (FVA) when pricing OTC derivative contracts. On one hand, theorists claim that value should not be accounted for as it leads to arbitrage opportunities. On the other hand, practitioners say they need to account for it, as otherwise their cost base is not reflected in the price of a contract. On the surface these claims seem to be contradictory, but upon closer examination in fact they are not. In this paper, we define FVA, explain its role, how it interacts with CVA, and how it should (and should not) be used in an organisation. We shall see, however surprising it may sound, that this debate can be seen as a semantic misunderstanding. The two sides of the argument are using the same word `price’ for two very different things: `fair price’ and `value to me’. Noting this, the paradox disappears, and we may properly understand the role of CVA, DVA and FVA in an organisation.