Funded Inside: The Internal Transfer of Costs and Risks from Collateralized and Funded Derivatives

Abstract

By introducing a funding cost component like a funding valuation adjustment (FVA) into the valuation of derivatives, the replication strategy inherent in the valuation approach needs to be reflected in the real management of the position. Whilst in theory the replication takes place in one self financing portfolio, the roles in an institution is often split between various functions like trading, collateral management or treasury. The first part of the article revisits the dynamic replication of the derivative to maintain profit and loss neutral position with respect to the funding. The second part focuses on the roles that are involved in the replication strategy and the required internal transactions between these roles. This serves as a starting point to assign the roles to existing functions or the setup of dedicated functions.