An Indifference Approach to the Cost of Capital Constraints: KVA and Beyond

Abstract

The strengthening of capital requirements has induced banks and traders to consider charging a so called capital valuation adjustment (KVA) to the clients in OTC transactions. This roughly corresponds to charge the clients ex-ante the profit requirement that is asked to the trading desk. In the following we try to delineate a possible way to assess the impact of capital constraints in the valuation of a deal. We resort to an optimisation stemming from an indifference pricing approach, and we study both the linear problem from the point of view of the whole bank and the non-linear problem given by the viewpoint of shareholders. We also consider the case where one optimises the median rather than the mean statistics of the profit and loss distribution. * The authors are grateful to Silvia Frasson, Massimo Morini, Silvia Orsenigo and Andrea Prampolini for helpful discussion on the practices of exposure management and capital requirements.

Risk-Neutral Valuation Under Differential Funding Costs, Defaults and Collateralization

“…More recently, KVA has started being discussed for the cost of capital one has to set aside in order to be able to trade. We will not address KVA here, since even its very definition is currently subject to intense debate in the industry, but we point the reader to [14] for an indifference pricing approach based on the risk-adjusted return on capital (RAROC).…”