Trading desk Cost of Carry ( funding)

[ORD]

Hi, When calculating the cost of funding of the trading desks in a bank , i understand , you multiply the banks funding rate ( can be diffrent in any bank ) by the "Carry" - what the desk uses . my question is how to calculate the trading desk, use of funds ? is it by MTM of his possissions , or by the actual cash flow it uses ?

 

[longgamma]

Hello,

So your treasury should specify two rates - secured funding and unsecured funding rates. Ideally, you should get secured funding rates if your assets have collateral value. So your product control team would just do this (mtm at close * secured cost of fund / 360). Also do note it depends on currency your fund as well. If you do cross currency stuff then be mindful of the FX risk.

Now what notional to use depends on your bank basically. Ideally it should be cost basis of your trade but the banks I worked earlier used MTM. So in rising markets if your derivatives interest accrual doesnt happen daily you end up running a basis risk. It gets quite costly when the positions are large.

 

[ORD]

thank you , very helpful. i would like to add to the question : in a transaction where there is no cash transfer till maturity eg. simple forward trade there is a mtm value . what is the rational for charging the desk for a cost of funding if there is no actual funding needs from treasury until maturity .

 

[IntoDarkness]

unless the daily or initial margin agreement i wouldn't think its reasonable to charge forward trade

 

[longgamma]

thank you , very helpful. i would like to add to the question : in a transaction where there is no cash transfer till maturity eg. simple forward trade there is a mtm value . what is the rational for charging the desk for a cost of funding if there is no actual funding needs from treasury until maturity .

Well won't you hedge your forward vs the client? The hedge basket sits on the balance sheet and incurs cost of funding which is how the futures and forward prices are derived from spot.

Additionally, any gain or loss from the derivative sits on the asset or liability side of the balance sheet but you won't get charged for it.

 

[ORD]

Thank you !
so if i understand correctly, if the bank chooses to use the mtm on the balance sheet as the "carry" ( probably because of data and system issues preventing the ability to use desk cash balance or cash flow ) then the all otc products including forward with no cash transaction will have a funding cost , but that cost is offset by the opposite hedging mtm .
did i get that correctly ?

 

[longgamma]

I am not sure what you mean but did you refer to forward pricing derivation in any textbook? The no-arbitrage pricing is derived with an assumption that you quote a forward while hedging the market risk, i.e, buying the underlying and holding it to maturity. F = S*exp(rT) essentially refers to this. That is why we use, r as the cost of funding to arrive at your fair value based on your bank's cost of funding. It could differ from the market but that is fine.

EDIT: regarding the choice of mtm or cost of funds, not sure what is the reasoning behind each bank's methodology. I have worked in two IBs and both of them used the MTM to work out the cost of funds. It is like paying your house's mortgage based on its current value rather than what you borrowed to buy it! Usually, most derivatives reset monthly so the gap risk is usually limited to one month.