Coherent CVA and FVA with Liability Side Pricing of Derivatives

Abstract

This article presents FVA and CVA of a bilateral derivative in a coherent manner, based on recent developments in fair value accounting and ISDA standards. We argue that a derivative liability, after primary risk factors being hedged, resembles in economics an issued variable funding note, and should be priced at the market rate of the issuer's debt. For the purpose of determining the fair value, the party on the liability side is economically neutral to make a deposit to the other party, which earns his current debt rate and effectively provides funding and hedging for the party holding the derivative asset. The newly derived partial differential equation for an option discounts the derivative's receivable part with counterparty's curve and payable part with own financing curve. The price difference from the counterparty risk free price, or total counterparty risk adjustment, is precisely defined by discounting the product of the risk free price and the credit spread at the local liability curve. Subsequently the adjustment can be broken into a default risk component -- CVA and a funding component -- FVA, consistent with a simple note's fair value treatment and in accordance with the usual understanding of a bond's credit spread consisting of a CDS spread and a basis. As for FVA, we define a cost -- credit funding adjustment (CFA) and a benefit -- debit funding adjustment (DFA), in parallel to CVA and DVA and attributed to counterparty's and own funding basis. This resolves a number of outstanding FVA debate issues, such as double counting, violation of the law of one price, misuse of cash flow discounting, and controversial hedging of own default risk. It also allows an integrated implementation strategy and reuse of existing CVA infrastructure.