14.4 Optimisation of CVA, DVA and Funding Costs
Collateral agreements reduce CVA, although the residual risk is hard to quantify. Furthermore DVA and FVA complicate the understanding of the overall benefit of a CSA. Therefore, an interesting question is to ask now is how an institution might optimise BCVA and FVA in their trading activities. This will require a look at the impact of collateral agreements on the BCVA and FVA components. We will then consider the impact of central clearing. Finally, we will discuss the overall optimisation of BCVA, FVA and regulatory capital.
14.4.1 The Spectrum of Trading with BCVA and FVA
Let us consider, in more depth, the impact of collateral on transactions such as derivatives. Generally, there are three broad situations to consider:
- Uncollateralised trades. The advantage of uncollateralised trades is that the main issue is CVA (and the associated regulatory capital charges), which an institution can attempt to quantify and manage. This makes it most straightforward to identify the cost of trading at inception and incorporate this into prices. However, CVA hedging is far from trivial as, under Basel III, capital relief is not achieved on market risk hedges (Section 17.4.5) and only a limited relief28 is given for credit index hedging (a single-name CDS market, which would allow close to 100% capital relief, does not exist for most counterparties). Furthermore, the difficult topic of DVA must be also considered.
- CSA trades. A CSA has the effect ...