So what exactly is the rate you are borrowing at to fund that derivative? January 16, 2014 at 10:14 pm

As everyone who has been paying attention knows, JPM had a $1.5B FVA hit in their most recent results. Matt Levine riffs amusingly if sometimes a little inaccurately* about a couple of aspects of this, my favourite part being:

there is… some gap between “my funding cost” and “FVA.” It’s unclear to me how much of JPMorgan’s model is based on their own funding costs and how much is based on some “market” funding cost; the earnings deck talks about “market funding rates” and “the existence of funding costs in market clearing levels,” so it seems that they’re thinking more about a market price of funding than they are about their own cost of funding.

Oh one fun fact about that. That earnings deck says that FVA “represents a spread over Libor”; based on [JPM CFO] Marianne Lake’s comments you can guess that that spread is around 50 basis points. That is, banks fund at around Libor plus 50 basis points.

Libor, you’ll recall, is supposed to be the rate at which banks can fund themselves.

I will resist the temptation to add a smilie.

*Hint: when a lawyer rights about how exactly Black Scholes works, you might want to apply a pinch of salt. Or read a careful account of the story, for instance here or here (where the key role of the replicating portfolio is explained – although I buy the Albanese ‘not fungible with debt’ argument).

4 Responses to “So what exactly is the rate you are borrowing at to fund that derivative?”

  1. Any suggestion that the effect of this adjustment is to take trading revenue out of the “dead” bonus year of 2013, and leave it available to be dumped into the P&L of a future year, more or less at the discretion of the finance department responsible for the funding cost assumptions, is clearly the bitter and sarcastic view of someone who doesn’t udnerstand the subtleties of derivatives valuation and probably did an arts degree. After all, that would be exactly the kind of earnings smoothing behaviour that simply isn’t possible under modern accounting standards.

  2. Now that really does get a smilie, thank you d^2. :-)

  3. Here is a thing I do not understand about CVA and FVA: it seems to me that if you calculate both independently, you risk substantial double-counting. Suppose I, a bank, have entered into a 10 year interest rate swap with a BBB- rated corporate with liquid CDS in which the corporate pays the floating leg. This swap generates substantial credit exposure for me, and also requires that I pony up meaningful balance sheet for the first half of the trade with an expectation of later repayment. Now suppose I collect my 10 bps running for CVA on the trade and send it down to the helpful CVA desk, who goes out and does a pretty good job matching CDS positions to the exposure such that my credit risk is limited – and that, on average, I’ve done an OK job of pricing CVA so it costs about the same 10 bps running. Note that I’ve almost certainly also hedged the rate risk.

    And yet, my FVA on this combined book of business will be charged at my risky blended all-in cost of funding (whether that’s LIBOR, or LIBOR+, or whatever). This seems weird to me – the risk on these combined trades, if I’m doing anything like a reasonable job at hedging, is some kind of short-term gap risk, that rates move quickly and I can’t cover my position fast enough with additional CDS and then my counterparty goes bankrupt. Could happen, for sure, but I would still expect on net this is pretty low-risk proposition. Shouldn’t my FVA be calculated on a lower funding cost to reflect the low risk of this particular activity? And if all FVA is charged to all businesses in a bank at the same rate, aren’t the less risky activities, like hedged underwriting of derivatives to corporates, just subsidizing riskier activities, like unhedged participation in high yield revolver commitments?

  4. mg, that would typically be handled by allocating and charging for cost of capital for the different desks.

    Since derivatives receivables are typically funded by general unsecured debt, unless the two businesses are in different legal entities that issue their own debt, the marginal cost of funding is really the same for them.

    For securities, the funding cost charged would indeed be different depending on the risk of the security, typically it will be the repo rate for that class of security, unless it’s not repo-able.