In defence of FVA – a response to Hull and White
The funding valuation adjustment traders have been adding to derivatives prices since bank funding costs first blew out in 2008 has proved controversial, putting theory and practice at odds with one another. Royal Bank of Scotland’s Stephen Laughton and Aura Vaisbrot make the case for the defence
In theory, derivatives pricing is a simple business, in which market-makers all agree on a single price, based on a risk-neutral expectation discounted at the risk-free rate. Since the crisis, this has become an increasingly poor description of reality, as prices have been adapted to reflect the funding costs of banks through a so-called funding valuation adjustment (FVA).
But this practice is
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