To manage the risk associated with this swap, the bank enters into a second swap with another financial institution in the market. This second swap is collateralized, meaning both parties post collateral to cover future obligations.
Suppose the swap between the bank and the client has a positive value for the bank (i.e., the bank is expected to receive net payments from the client). Consequently, the hedging swap in the market has a negative value for the bank (i.e., the bank will need to make net payments to the market counterparty).
Under the collateralized agreement, if the value of the swap decreases (becomes more negative) for the bank, the bank must post additional collateral remunerated at a benchmark rate such as the Euro short-term rate (€STR) to secure the hedging swap.If the swap with the client were also collateralized, the bank would have a symmetrical arrangement, receiving a margin call if the client swap decreases in value and needing to pay a margin call if the value increases. However, since the client swap is uncollateralized, the bank must finance the margin call for the hedging swap at its internal funding rate, which is typically higher than the €STR.
The difference between the cost of financing the margin call and what the bank would have received if the client swap were collateralized results in a loss (negative margin).
When the bank must finance a margin call at a higher internal rate than the rate specified by the CSA (Credit Support Annex), this creates an accounting loss, recorded as a negative FVA.
Conversely, if the situation is reversed (the client derivative has a negative value and is uncollateralized, while the market derivative has a positive value and is collateralized), the bank may gain a positive margin, recorded as a positive FVA, i.e a funding benefit adjustment (FBA).
(*) OIS (Overnight Index Swap) reflects the overnight interbank rate through derivatives, while ESTER or €STR (Euro Short-Term Rate) is based on actual overnight borrowing costs in the euro area. A bank's funding rate, is often higher than benchmarks like €STR due to added risk premiums.
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