Risk 25: The FVA debate

Derivatives pricing practices have been overhauled in recent years, with banks becoming more conscious about funding costs. But should dealers take funding valuation adjustment into account when valuing derivatives and making trading decisions? John Hull and Alan White argue they should not

John Hull and Alan White
John Hull and Alan White, University of Toronto

When valuing European options in the early 1970s, Fischer Black, Myron Scholes and Robert Merton (BSM) showed that, over any short period of time, an investment in an option could be replicated with a portfolio of stock and risk-free debt. This observation allowed them to calculate the economic value of the option by solving a differential equation. Subsequent analysis showed the economic value of the option could also be determined by discounting the expected pay-off on the option in a risk

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