A dealer holds an uncollateralised ten year swap whose expected positive exposure averages $5m over its life, and funds at 50 basis points over the discount curve. What is the funding valuation adjustment, and what does a two way credit support annex with daily cash margin change?

A dealer holds an uncollateralised ten year swap whose expected positive exposure averages $5m over its life, and funds at 50 basis points over the discount curve. What is the funding valuation adjustment, and what does a two way credit support annex with daily cash margin change?

Approach: Charge the funding spread against the exposure the dealer has to carry, integrated over the life of the trade. Then ask what remains once the exposure is margined daily.

$250,000. The dealer borrows to carry a positive mark to market, so the funding valuation adjustment integrates the spread against the expected positive exposure: roughly 0.005*5m*10 = $250,000 before discounting, and a little under that once each year's charge is discounted back. A two way credit support annex with daily cash margin removes almost all of it, because the exposure is collateralised each day and the unfunded amount shrinks to the margin period of risk, while the swap is discounted at the rate paid on the collateral rather than at the dealer's own funding curve. What survives is initial margin, which is posted, funded and remunerated below cost, giving a separate margin valuation adjustment. That difference is why the same ten year swap quotes several basis points wider to a client with no collateral agreement.

Follow-up: How does the adjustment change when the exposure profile is symmetric, so the dealer is sometimes posting and sometimes receiving?

Key concepts: funding valuation adjustment, expected positive exposure, collateral, discounting.