What is FVA (Funding Valuation Adjustment), and why is there a heated academic debate about whether it should exist?

FVA (Funding Valuation Adjustment) reflects the cost or benefit of funding uncollateralized derivative positions. When a dealer enters a derivative that requires funding (e.g., posting collateral on one side but not receiving it on the other), the funding cost exceeds the risk-free rate. FVA captures this spread.\n\nHow FVA Arises:\n\nConsider a dealer who enters a swap with a corporate client (no collateral) and hedges with an interdealer swap (collateralized). The dealer must fund the initial margin on the hedge but receives no collateral from the client.\n\nDealer's funding cost: SOFR + 85 bps (their credit spread)\nCollateral earns: SOFR\nFunding spread: 85 bps on the expected funding requirement\n\nFVA Calculation:\n\nFVA = -Integral from 0 to T of [s_f x EFE(t) x DF(t) dt]\n\nWhere:\n- s_f = funding spread above OIS\n- EFE(t) = expected funding exposure at time t\n- DF(t) = OIS discount factor\n\nWorked Example:\n\nWeatherstone Bank executes a $300M 7-year uncollateralized swap with Langley Industries. Weatherstone's funding spread is 92 bps.\n\nSimplified expected funding exposure profile:\n\n| Year | EFE ($M) | DF | Contribution |\n|---|---|---|---|\n| 1 | 3.2 | 0.955 | $28,096 |\n| 2 | 5.8 | 0.912 | $48,643 |\n| 3 | 7.5 | 0.871 | $60,069 |\n| 4 | 8.1 | 0.831 | $61,903 |\n| 5 | 7.3 | 0.793 | $53,246 |\n| 6 | 5.6 | 0.757 | $38,981 |\n| 7 | 3.0 | 0.722 | $19,927 |\n\nFVA = 0.0092 x Sum = 0.0092 x $310,865 = $310,865\n\nWeatherstone must charge this upfront to cover expected funding costs.\n\nThe Academic Debate:\n\n| Position | Argument |\n|---|---|\n| Practitioners (Pro-FVA) | Funding costs are real. Ignoring them means trading at a loss. Every major dealer charges FVA. |\n| Academics (Anti-FVA) | In complete markets, derivatives should be valued independently of who funds them. FVA double-counts DVA. Hull & White (2012) called it a \"theoretical error.\" |\n| Middle ground | FVA may not belong in fair value but is a legitimate cost that affects trade profitability and should influence pricing decisions. |\n\nThe practical reality is that FVA is now universally charged by dealers. The debate has shifted from whether FVA exists to how it should be allocated and reported.\n\nLearn more about FVA implementation in our FRM Part II course.