X-Value adjustments: accounting versus economic management perspectives

TL;DR

This paper introduces a mathematical framework based on invariance principles to classify financial institutions' credit, debit, and funding adjustments from accounting and management perspectives, aiding in understanding their differences and transition implications.

Contribution

It provides a novel classification method and an improved calculation approach for adjustments, independent of discounting curves, facilitating perspective shifts within financial institutions.

Findings

Classifies institutions into paradigms based on adjustment calculation methods

Offers an improved, approximation-free solution for invariance equations

Clarifies implications of switching between accounting and management perspectives

Abstract

This paper provides a mathematical framework based on the principle of invariance to classify institutions in two paradigms according to the way in which credit, debit and funding adjustments are calculated: accounting and management perspectives. This conceptual classification helps to answer questions such as: In which paradigm each institution sits (point of situation)? Where is the market consensus and regulation pointing to (target point)? What are the implications, pros and cons of switching perspective to align with future consensus (design of a transition)? An improved solution of the principle of invariance equations is presented to calculate these metrics avoiding approximations and irrespective of the discounting curve used in Front Office systems. The perspective is changed by appropriate selection of inputs always using the same calculation engine. A description of balance sheet financing is presented along with the justification of the funding curves used for both perspectives.