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Jockle: Thank you. So John, your recent research has focused on FVA and you've been an important player in the industry debate around it. Much of this ongoing FVA discussion centers on whether funding adjustment is appropriate for derivative pricing. Some are arguing that FVA is an integral component of OTC derivatives pricing. While others, like yourself, make the case that FVA is not necessary and in violation of fundamental asset pricing theory. What are the issues that people on both sides of this debate are in disagreement about?

Hull: Well Jim, you're absolutely right. When Allan White and I first wrote this article for Risk Magazine back in July of this year, we never expected there to be a huge amount of controversy and debate and the interest that there has been. We've received no end of emails about this article. And, I think the reason is that there are lots of arguments on both sides here. The arguments that we used, I'll start with those. First of all in any traditional corporate finance course that you might get taught in university, we make the argument that investment decisions should be kept separate from financing decisions. The decision about whether to go ahead with an investment should depend on the risk of that investment; it shouldn't depend on the average funding costs of the company that's doing the investment. So that was one point, FVA is sort of mixing up the funding of derivatives from how attractive those derivatives are as investments. So that was the first point in our argument.

We also talked about risk neutral valuation, which is a long established principle in the pricing of derivatives. And basically risk neutral valuation argues that if you assume the world is risk neutral, you get the right price, not just in the risk neutral world but in other worlds as well. So that's an argument in favor of discounting at the risk-free rate and not mixing it up with funding costs.

And then the third type argument that we had was concerned with the relationship between FVA and something called DVA, which is the firm's own credit risk adjustment.

So those were the arguments on our side. The arguments on the other side were, if, let's just take the example of the bank's funding costs being the risk-free rate plus 200bps. The bank's got to recover that risk-free rate plus 200bps, the funding desk will charge the derivatives desk the risk-free rate plus 200bps, so the derivatives desk better earn the risk-free rate plus 200bps. So, the arguments from the other side were more about flows of funds within the bank, and whether the funds that were flowing from one part of the bank to another part of the bank were getting an adequate return on those funds.   I think the sort of debate one gets into here is something like the following, and indeed we have gotten into this debate with a lot of different people.

Let's suppose a bank does fund itself at the risk-free rate plus 200bps, and it comes across this investment which is almost risk-free - of course almost nothing is totally risk-free - it's almost risk-free, but it returns the risk-free rate plus 150bps. So it's a great investment, almost risk-free, and it's giving you 150bps above the risk-free rate, but the bank is funding itself at the risk-free rate plus 200bps. So should you go ahead with that investment? That's perhaps what a lot of the debate we've had with people has centered around. We would argue that yes you should, it's a great investment. What you should do is look at the riskiness of that investment in deciding whether to go ahead with it, not worry about what the average funding costs of the bank is because those average funding costs relate to the average risk of everything the bank is doing, not just that particular investment. Then the next stage in that argument is, well ok if the bank does a lot of those almost risk-free investments its average funding costs will go down because it's a less risky bank. Then the other side will say, oh that never happens, you know the funding markets are very sticky, they're not efficient in that way. You can't expect your funding costs will go down because you did less risky investments.   

So those are the sort of arguments that were around on both sides of this debate. One important distinction here - and I think both sides agree this is a distinction - is the difference between what accountants call the fair market value of a derivative, and what we call the private value. In other words, the fair market value should be the value which is generally considered to be the correct value by market participants. The private value could be different for different financial institutions depending on other things they have in their portfolio, particular objectives they're trying to meet, maybe even their funding costs as well. So you can see that there's a lot of accounting issues that play into this, sometimes regulator issues that are brought in, and then the sort of basic fundamental finance theory.

Jockle: So are there any particular adjustments that you would make to the prices of derivatives, given traditional models like Black-Scholes?

Hull: Well that's a good question. A traditional model such as Black-Scholes assumes that when two sides enter into a derivatives transaction, they're both going to live up to their obligations; neither of them are going to default. So one adjustment that the derivatives industry has become progressively sophisticated in making is the credit risk adjustment.

We've got two adjustments, CVA and DVA. CVA is a fairly straight forward one. CVA says if I enter into portfolio derivative transactions with you, you might default and you might default at a time when I have an exposure, in that the value of the transactions have a positive value to me and a negative value to you. I have to take that into account in valuing the transactions. I would value the transactions first assuming that neither of us would default, then I'll subtract this thing called CVA, credit value adjustment, to reflect the possibility that you might default.

Then I'll say, well as symmetry would suggest I should also make an adjustment for the fact that I myself might default, and that's actually a benefit to me. That's called DVA, so that's something you would add to the value of the derivatives portfolio. So the actual derivatives portfolio... Everybody would agree, I mean accountants agree, that we should first calculate the no default value of the derivatives portfolio, subtract CVA and add DVA. Now I might go one stage further and say that there should be an adjustment for liquidity risk as well. Although the liquidity risk adjustment is very difficult to estimate. But if we suppose that a bank has some dead weight cost of borrowing that is unrelated to credit risk, and we're calling it liquidity risk. And its something that all banks have, everybody in the market place right now has to pay this liquidity premium regardless of the credit risk, then you could argue that that's a dead weight cost of borrowing and it should be taken into account in any investment decisions that you make. So it's a situation where funding and investment do interact if you like. The real problem is that it's very difficult to estimate what the liquidity premium is in the market at any given time because you've got to distinguish between the liquidity premium and the credit risk premium - because when markets become stressed, the credit risk premium goes up as well as potentially there being a liquidity premium.

But what some people have tried to do is estimate the liquidity premium as the excess of the bank's borrowing credit spread over the CDS spread, sometimes called the CDS bond basis. In other words, the excess of the bond yield spread over the credit default swap spread. And so the CDS bond basis is actually calculated the other way around, so it could be the extent of the negative CDS bond basis is a measure of the liquidity spread. The only problem with that, I mean that's about as close as you can get, the only problem with it is that the CDS spread itself is influenced by supply and demand factors which are unrelated to liquidity in the bond market, so it's very difficult to separate everything that's going on out there.   

Jockle: And John I know you had a recent guest contribution on Amazon.com's Money and Markets blog where you raised some of the forthcoming issues of managing liquidity. Would you categorize this as the next greatest challenge in the OTC derivatives markets?

Hull: I think it already is as a matter of fact a big challenge in the OTC markets. I think all of the regulatory changes which are going on in the OTC markets have really raised the importance of liquidity a huge amount. Basel III, as you may know, has got two liquidity ratios which banks will down the road have to adhere to - the liquidity coverage ratio and the net stable funding ratio.

Banks are obviously going to have to be a lot more conscious of liquidity because of those ratios, but there's other reasons as well. Transactions in the OTC derivatives markets, some of them will be going through central clearing parties - many more of them than have done in the past - and some of them will continue to be bilaterally cleared, but whichever category they're in the regulations require more collateral.

So banks will have to post more collateral for the derivatives that they're entered into, and as far as central clearing parties are concerned that collateral has to be pretty liquid stuff, it has to be typically cash and government bonds, and banks have to be ready at a moments notice to provide more collateral if the CCP asks for it. You can see how that creates a lot more pressure to hold liquid assets in your balance sheet, and it means that holding things like loans to corporations, mortgages, and so on on your balance sheet which are inherently illiquid, will be very unattractive. So there's going to be a lot of pressure to securitize those and that sort of thing. I see liquidity becoming progressively more important. And it will be interesting to see how financial institutions trade off liquidity and capital. You can imagine that there could be a project that comes along that will actually reduce your regulatory capital, so it's an attractive project from that point of view, but it might actually increase your liquidity requirements. So you'll have to think about the tradeoff between the two. And I think we'll see a lot more discussion of that sort of thing going forward.

Hull: Thanks Jim.