This is one of a number of reports from academics associated with the Swiss Finance Institute, a leading organisation encouraging new thinking in economics and finance in Switzerland and beyond.

Time value of money

This following article is by Paolo
Vanini, who is director of knowledge transfer at the Swiss Finance Institute
and adjunct professor for banking at the University
of Basel in Switzerland. He is responsible for
the Department of Structured Products & Cross Assets at Zurich Cantonal
Bank. This topic, relating to the core financial principle that money has “time
value”, can be extremely complex at times, such as when valuing derivative
products, a process that became very challenging in the financial crisis and
its aftermath for some time. Given that derivatives are widely used in modern financial services to hedge risk and capture returns, it is useful to understand some of the more arcane-seeming aspects of the field. This publication is grateful to Professor Vanini
and the Swiss Finance Institute for this article; we intend to publish more
material from the SFI’s network of academics in the coming weeks and months.

The time value of money is a fundamental concept in economics and
influences every financial decision we make. A better understanding of the
concept is particularly important in over-the-counter derivative markets. The most
recent financial crises radically changed our view of what is important in the
valuation of the Swiss franc. The general wisdom found in finance text books no
longer holds true: Counterparty risk, funding, and liquidity risk significantly
affect the time value of money.

To illustrate such points, late last month, a Swiss Finance Institute
conference on the time value of money explored “Essentials in Credit Risk,
Liquidity, and Funding”. The event, held at ETH Zurich, attracted more than 100 hundred
participants, mostly from the Swiss finance and banking industry. 

Experts from major banks and academia including Professor Andrea
Pallavicini (Banca IMI and Imperial College London), Dr Chris Kenyon (Lloyds
Bank), Gordon Lee (UBS), Dr Holger Plank (d-fine), and Dr Stefanie Ulsamer ZKB (Zurich
Cantonal Bank) gave insights into the progress researchers and practitioners have
made in this field in recent years.

Attendees first learned of the recent shift away from credit valuation
adjustment and toward funding valuation adjustment, a shift caused by
collateralisation initiatives in over-the-counter derivative markets (central
counterparty clearing). It was also made clear that, while people agree on what
CVA is and how it should be calculated, very diverse opinions coexist regarding
FVA, how it should be defined, and whether or not it plays any role at all in
OTC derivative pricing. (CVA is the monetized value of the counterparty credit
risk; FVA is the funding valuation adjustment.)

In its extreme form FVA is, in some theoretical models, a complicated
recursive scheme, while for other practitioners it is merely the treasury
funding curve. To become a market standard in the future, the answer to the
question - “What is FVA?”
must lie somewhere in between these two extremes.

The complexity of these issues was another subject broached in
conference presentations. While pricing an interest rate swap is
straightforward without these concepts, incorporating CVA turns the swap into
an option (a “swaption”) where credit and market risk both need to be
considered and where legal constraints such as CSA close-out netting agreements
matter.

It is therefore of no surprise that large, internationally active banks
have implemented systems for CVA, DVA, and FVA calculations for both pricing
and hedging, while many smaller banks will fail to do so due to lack of know-how.
Exactly how this asymmetry between market participants will affect business
models and earnings in OTC derivative markets remains an open question.

Conference presentations also made clear how the entire debate is situated
in the triangle between trading, accounting, and regulation. While some issues
and concepts make sense from an accounting point of view (DVA), from a
regulatory standpoint certain perverse incentives are generated.

In conclusion, a coherent and comprehensive concept of the time value of
money of OTC derivatives, which is sound for trading, accountancy, and
regulatory authorities, is still to be found.