We demonstrate the incorrectness of large funding value adjustments (FVAs) being made by derivatives dealers to the accounting valuations of their swap books. Essentially the same funding cost adjustment should instead be made to a dealer’s equity value. This reduction in equity value is exactly offset by the sum of an upward adjustment to a dealer’s debt valuation (as a wealth transfer from shareholders) and a change in the present value of the dealer’s financial distress costs. While it has already been suggested by some observers that FVA accounting is incorrect, this paper provides the first model that demonstrates this. In addition to giving an appropriate theoretical foundation for funding value adjustments, our model shows how dealers’ bid and ask quotes should be adjusted so as to compensate shareholders for the impact of both funding costs and the dealer’s own default risk. We also establish a pecking order for preferred swap financing strategies, characterize the valuation effects of initial margin financing (MVA), and provide a new interpretation of the standard debt valuation adjustment (DVA).
Based on joint work with Darrell Duffie and Yang Song