Effective Product Control

CHAPTER 16Valuation Adjustments

In this chapter, we will look at why valuation adjustments are required and will explore some of the more common valuation adjustments that are applied to trading desks.

Why Valuation Adjustments Are Required

In an ideal world, the trade valuation generated by the risk management system (RMS) would be the financial asset's or liability's fair value, but due to system limitations this rarely happens. Valuation adjustments (VAs), which are also known as reserves, are necessary adjustments to bring the RMS valuations, of financial assets or liabilities, to their fair value (see Chapter 4 for a definition of fair value).

Figure 16.1 illustrates how a financial asset's or liability's valuation transforms into an exit price. In Figure 16.1, the bank executes a trade at the market price, which is then fed into the RMS, where it is typically revalued at a mid-market price.

Figure 16.1 Aligning valuations to their exit price

To transform the mid-market price to an exit price, several VAs need to be applied. In Figure 16.1 I have listed the most common types of VAs which we will look at in more detail shortly.

When these VAs are applied, in most cases they will lower the value of the financial asset and increase the value of the financial liability (i.e., make it a larger liability), which results in a loss for the desk.

VAs can be taken when trades ...