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.