Jan 7, 2015

Derivative Practitioners Tackle Regulatory, XVA and Trade Profitability Challenges

The question at the root of any OTC derivatives’ trading decision process, “Is this trade profitable?,” may at its core seem like a simple proposition. But with the ever-changing landscape slated for OTC derivatives in 2015, the issues of adjustment calculations and trade profitability continue to grow increasingly complex.

As we ring in the new year, financial institutions trading in derivatives are facing mounting pressures on their current business models, with a slew of new regulations—including Dodd-Frank and Basel III— anticipated to be rolled out and implemented in the upcoming year and beyond. To survive and thrive in yet another new year of derivatives trading, we are seeing a continued trend amongst financial institutions moving toward more integrated and holistic approaches for assessing trade profitability and allocating capital to their businesses.

In 2015, we anticipate the flurry of XVAs (a term which now includes FVA, CVA, DVA, KVA and still other adjustments) to continue to bring on a snowstorm of complexities when it comes down to P&L and trade profitability. Though differing viewpoints still exist, by now the majority of financial practitioners have come to accept that FVA (Funding Valuation Adjustment) is a real charge, affecting the profitability of trades—yet many institutions are still debating the best way to manage this cost, along with the smorgasbord of others they are facing.  And, with a reported 10 banks now incorporating the cost of funding into the value of derivatives trades, we continue to see why it is so imperative to know this cost in order to make the best business decisions.   

In the coming year, we anticipate the growing trend to continue amongst practitioners who are translating the concept of Economic Value Added (EVA)—a global profitability measure—into the derivatives lexicon.  We recently discussed how the concept of Trade EVA is an effective way to measure and attribute risk, funding and capital cost to each individual trade.  Furthermore, our research shows that creating a trade profitability framework and bringing the XVAs into trading decisions will potentially enable better decision making amongst financial institutions. For example, our study highlights how a trade that is profitable at first glance can turn out to be a loss-making trade when all costs are incorporated.

For more information, read our recently published paper Integrating Risk into Pre-Trade Analysis: Practical Ways of Bringing Credit, Liquidity, Funding & Regulatory Costs into an Integrated Profitability Framework authored by  Satyam Kancharla, Chief Strategy Officer & SVP of the Numerix Client Solutions Group.


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