GoldenSource

XVA XVA emerged after the GFC as a set of valuation adjustments applied to the classical risk-neutral valuation framework. OTC options are priced by a) predicting forward prices of the underlying, and b) discounting those forward prices to PV. In the 1970s and 80s, risk-neutral valuation theories were developed which allowed prices of options to be simulated as functions of the underlying. The essence of those theories was the substitution in option formulas and simulation processes of the difficult to estimate underlying price, μ, with the directly observable risk-free rate, r. Once r had replaced μ, the discounting processes in b) above became standardised for all types of derivatives. Applying them meant that prices of derivatives could be easily modelled as discounted asset prices which in turn allowed future derivative prices to be modelled consistently from current market prices. That is, discounted derivative prices could be modelled as martingales. The RNV framework became the foundation for derivative pricing for the next three decades with LIBOR indices acting as proxies for r. In 2008, the GFC disrupted the simplicity of RNV martingale pricing. Inter-bank LIBOR rates became a poor proxies for r and banks and financial markets were forced to fit RNV theory into the reality of their institutional funding frameworks. In the largest, most important derivatives market - the IRD market - a) and b) above had to be split into projection curves and funding curves with OIS rates acting as the benchmark for funding curves. The unrealised gains on derivatives became material credit risks and rates used in funding curves were forced higher where the credit quality of collateral posted was deemed lower. Banks started charging upfront fees (CVA) for the risk of default by derivative counterparties and they started accounting for the expected benefit from their own default (DVA). FVA emerged when they realised the cost of funding collateral posted on unrealised losses was materially higher than the risk-free rate, r, and some banks started charging MVA to counterparties as the pass-through costs of funding initial margin. KVA became the PV of the lifetime opportunity cost of setting aside the capital regulators were now insisting on for credit and market risk. The GFC did not invalidate RNV theory. Instead, it embedded it within the institutional realities of collateral, funding, capital and counterparty credit risk. The term XVA began to be used around 2010-2012 as banks brought the hedging and management of the post-GFC valuation adjustments under centralized XVA desks.

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I had such a blast at my 20th Carnegie Mellon University reunion this weekend. Coming back as a full-fledged adult gave me a new appreciation for so many things I didn’t notice back when I was on campus. The history, the opportunities, the availability of amenities, and especially the precious time we had with our peers. Being surrounded by so many smart, driven, innovative people all in one place, at that moment in time, is truly a once-in-a-lifetime experience. Much is the same, but so much has changed. New CMU buildings, new restaurants in the surrounding area, and so much new development around Pittsburgh. It was heartwarming to see some beloved spots still around, like Rose Tea Cafe, which used to be one of my favorites. It was also special coming back as the charter class of alpha Kappa Delta Phi International Sorority, Inc. and meeting the active sisters, seeing how the sorority has grown and evolved over the years. The best part of the trip was definitely meeting all the new people and being able to spend real, quality time reconnecting with old friends. It’s fascinating to learn about all the different paths people have taken. So many different careers paths, so many interesting stories. I’m more proud than ever to be an alum of CMU. I’ll definitely be back for the 25th, and I hope to see even more of the Class of 2006 at the next reunion! (And thank you to my amazing husband for taking care of our toddler to make my trip possible!)

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