Financial-industry practitioners have begun to pay much more attention to economic costs embedded in derivatives transactions, for example to account for counterparty credit risk, funding and regulatory capital, which they previously ignored in valuations. To incorporate these terms, banks have started to compute and manage a set of valuation adjustments (xVAs) also prompting regulatory and accounting standards to catch up in recognising the same on the balance sheet.
With counterparty credit risk and funding practices converging in the industry, adjustments for regulatory capital and initial margin are still in flux. Regulatory capital and initial margin costs are difficult to compute precisely and hedge on the trading desk, which is complicating overall performance management and also requiring closer cooperation between the front office, risk and treasury.
This paper examines the evolution of xVAs from bespoke and arbitrary adjustments towards more integrated – and standardised – components of value. We also discuss ways stakeholders can get better insights into medium- to long-term profitability, including the need for enhanced governance, business steering and computation capabilities.