KVA: Capital Valuation Adjustment

TL;DR

This paper extends existing derivative valuation adjustments to include a Capital Valuation Adjustment (KVA), accounting for regulatory capital costs, and explores its calculation, hedging, and impact on derivative pricing.

Contribution

It formalizes the inclusion of KVA into derivative pricing using a semi-replication approach and discusses practical implementation under Basel regulations.

Findings

KVA significantly impacts derivative pricing.

Hedging KVA involves additional regulatory capital considerations.

Numerical examples illustrate the cost impact of KVA.

Abstract

Credit (CVA), Debit (DVA) and Funding Valuation Adjustments (FVA) are now familiar valuation adjustments made to the value of a portfolio of derivatives to account for credit risks and funding costs. However, recent changes in the regulatory regime and the increases in regulatory capital requirements has led many banks to include the cost of capital in derivative pricing. This paper formalises the addition of cost of capital by extending the Burgard-Kjaer (2013) semi-replication approach to CVA and FVA to include an addition capital term, Capital Valuation Adjustment (KVA, i.e. Kapital Valuation Adjustment to distinguish from CVA.) The utilization of the capital for funding purposes is also considered. The use of the semi-replication approach means that the flexibility around the treatment of self-default is carried over into this analysis. The paper further considers the practical calculation of KVA with reference to the Basel II (BCBS-128) and Basel III (BCBS-189) capital regimes and their implementation via CRD IV. The paper also assesses how KVA may be hedged, given that any hedging transactions themselves lead to regulatory capital requirements and hence capital costs. Finally a number of numerical examples are presented to gauge the cost impact of KVA on vanilla derivative products.