January 14, 2014 / 5:16 PM / 4 years ago

DERIVATIVES: JP Morgan books US$1.5bn FVA loss

LONDON, Jan 14 (IFR) - JP Morgan has recorded a US$1.5bn loss as a result of implementing a framework for funding valuation adjustments (FVA) in its derivatives and structured notes portfolios, in a further sign of the growing prominence of the controversial measure among the dealer community.

Banks have been working behind the scenes for several years on developing their own frameworks for calculating FVA - a measure used to account for the cost of bank funding in uncollateralised derivatives positions - in order to accurately price and value transactions.

Marianne Lake, JP Morgan's CFO, noted on a call with analysts today that there has been no broad consensus so far on whether funding should be incorporated into valuation estimates for derivatives. However, she said the firm believes market practices have noticeably evolved over the course of 2013.

"We've now accumulated compelling evidence both from transactions as well as industry pricing services that dealers are pricing funding into uncollateralised derivatives with a degree of consistency. This supports incorporating an FVA framework this quarter," said Lake.

The bank indicated the sizeable quarterly loss would be a one-off event as it incorporated the FVA framework into the valuation of its portfolios. From now on, FVA will be factored into derivatives valuations at the inception of a trade. This should significantly reduce JP Morgan's sensitivity to funding spreads going forward, Lake said.

Present Valuing

JP Morgan described FVA as a spread over Libor, which had the effect of "present valuing" - in other words, marking to market - a contract's funding costs rather than accruing these costs over the lifetime of the derivative. FVA is only applied to uncollateralised transactions; collateralised derivatives effectively fund themselves using the collateral backing the trade.

The FVA will vary depending on the size and tenor of the transaction, as well as the bank's own cost of funding. By way of example, Lake said if a bank held derivatives receivables net of cash and securities collateral of approximately US$50 billion, applying an average duration of approximately five years and a spread of approximately 50 basis points, that would account for about a billion dollars plus or minus the adjustment.

As a result of adopting the new framework, JP Morgan expects the volatility of profits and losses associated with FVA and debit valuation adjustments (DVA) - another measurement that overlaps with FVA - to be lower going forward.

FVA has sparked a lively debate in the derivatives world. Noted academic John Hull has argued that FVA should not be included in valuing derivatives as it moves away from risk-neutral pricing, while banks counter that it represents a real cost of doing business, and a substantial one at that. RBS, one of a handful of firms that has started making public disclosures, mentioned an FVA of £475m in its 2012 annual report.

Other industry professionals have criticised the lack of transparency around factoring FVA into derivatives valuations, and have called for the creation of a simplified market standard.

For more from IFR Magazine, go to www.ifre.com christopher.whittall@thomsonreuters.com

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