When we wrote our article arguing that, contrary to industry practice, derivatives prices should not include a so-called funding valuation adjustment (FVA) to reflect the cost to dealers of funding their hedging portfolios, the interest it would generate never occurred to us (Risk25 July 2012, pages 83–85, Risk September 2012, pages 18–22, and pages 23–24). Much to our surprise, we have been inundated with responses from practitioners all over the world, on both sides of the argument. It seems that, without intending to, we have touched a nerve. We respond here, and in a technical article available online.1
Laughton and Vaisbrot, Risk, In defense of FVA – a response to Hull and White, here.
Hull and White argue that the practice of charging clients for funding costs, commonly employed by derivatives traders since the 2008 financial crisis, has no basis in derivatives pricing theory. They use the Black-Scholes-Merton (BSM) theory to argue derivatives should be valued on a risk-neutral basis, independent of the cost to the trader of funding the position, but the theory rests on the ability of market participants to fully hedge all risk factors. In reality, they are not able to do so because markets are incomplete. As a result, risk preference is reintroduced into valuations, meaning individual judgements on risk are necessary, and the law of one price – which states that in an arbitrage-free market, two assets with the same risk characteristics should have the same price – no longer holds.1 In this context, applying the so-called FVA to the risk-neutral value, as happens widely today, is justified.
Stephen Blyth, Harvard, Big Ideas for Busy People, here.
“The Quant Delusion: The Rise and Fall of Financial Engineering”
Stephen Blyth | Professor of the Practice in Statistics, Harvard University; Managing Director, Harvard Management Company