Media Releases

New research on the valuation of over-the-counter derivatives from University of Toronto’s Rotman School of Management

June 5, 2013

TORONTO, ON — By some mea­sures the over-the-counter deriv­a­tives busi­ness is the largest busi­ness in the world with over $600 tril­lion in trans­ac­tions out­stand­ing. This busi­ness plays a sig­nif­i­cant role in the prof­itabil­i­ty of glob­al bank­ing insti­tu­tions.

Before 2007, banks agreed on the val­ue of most of these trans­ac­tions, but since the finan­cial cri­sis of 2007-09 there has been grow­ing uncer­tain­ty about deriv­a­tive val­ues. This cen­ters on the ques­tion of whether or not to make what is known as a “fund­ing val­ue adjust­ment” (FVA).  This is an adjust­ment to the price of a deriv­a­tive designed to reflect the bank’s fund­ing cost. It has the poten­tial to mis­state prof­its from deriv­a­tives trad­ing by a huge amount.

In a new study, two finance pro­fes­sors at the Uni­ver­si­ty of Toronto’s Rot­man School of Man­age­ment say that there is a dif­fer­ence between the way deriv­a­tives are val­ued for trad­ing pur­pos­es and the way they are val­ued by accoun­tants for report­ing pur­pos­es. It is this dif­fer­ence that is at the heart of the FVA debate. The way deriv­a­tives are val­ued for trad­ing pur­pos­es reflects the bank’s return on cap­i­tal per­for­mance mea­sure. But for report­ing pur­pos­es, the “fair val­ue” price of a deriv­a­tive is cal­cu­lat­ed in such a way that it is con­sis­tent with the prices of oth­er sim­i­lar deriv­a­tives that trade active­ly in the mar­ket.

Prof. John Hull, who holds the Maple Finan­cial Group Chair in Deriv­a­tives and Risk Man­age­ment, and Prof. Alan White, who holds the Peter L. Mitchelson/SIT Invest­ment Asso­ciates Foun­da­tion Chair in Invest­ment Strat­e­gy, argue that banks have a num­ber of choic­es. One alter­na­tive is to use two val­u­a­tions, one for inter­nal pur­pos­es and one for exter­nal report­ing pur­pos­es. The per­for­mance of the deriv­a­tives desk as mea­sured by return on cap­i­tal is then liable to be out of line with the report­ed per­for­mance. Anoth­er alter­na­tive is to change the return on cap­i­tal per­for­mance mea­sure so that it agrees with fair val­ue account­ing.  In the opin­ion of study’s authors, the best alter­na­tive is to use the trader’s mod­el to cal­cu­late breakeven trad­ing prices and the accountant’s mod­el for mark­ing to mar­ket and hedg­ing.

For the lat­est think­ing on busi­ness, man­age­ment and eco­nom­ics from the Rot­man School of Man­age­ment, vis­it

The Rot­man School of Man­age­ment at the Uni­ver­si­ty of Toron­to is redesign­ing busi­ness edu­ca­tion for the 21st cen­tu­ry with a cur­ricu­lum based on Inte­gra­tive Think­ing. Locat­ed in the world’s most diverse city, the Rot­man School fos­ters a new way to think that enables the design of cre­ative busi­ness solu­tions.  The School is cur­rent­ly rais­ing $200 mil­lion to ensure Cana­da has the world-class busi­ness school it deserves. For more infor­ma­tion, vis­it


For more infor­ma­tion:

Ken McGuf­fin
Man­ag­er, Media Rela­tions
Rot­man School of Man­age­ment
Uni­ver­si­ty of Toron­to
Voice 416.946.3818
Fol­low Rot­man on Twit­ter @rotmanschool
Watch Rot­man on You Tube: