Warehousing Credit (CVA) Risk, Capital (KVA) and Tax (TVA) Consequences

TL;DR

This paper extends existing models to quantify the effects of warehousing credit risk on capital requirements, profits, and taxes, incorporating tax considerations into credit and capital valuation adjustments.

Contribution

It introduces a novel double-semi-replication framework and TVA to quantify credit risk warehousing and tax impacts within capital and risk management models.

Findings

Quantifies the impact of credit risk warehousing on capital requirements.

Incorporates tax effects into credit and capital valuation adjustments.

Provides a comprehensive framework for risk, capital, and tax integration.

Abstract

Credit risk may be warehoused by choice, or because of limited hedging possibilities. Credit risk warehousing increases capital requirements and leaves open risk. Open risk must be priced in the physical measure, rather than the risk neutral measure, and implies profits and losses. Furthermore the rate of return on capital that shareholders require must be paid from profits. Profits are taxable and losses provide tax credits. Here we extend the semi-replication approach of Burgard and Kjaer (2013) and the capital formalism (KVA) of Green, Kenyon, and Dennis (2014) to cover credit risk warehousing and tax, formalized as double-semi-replication and TVA (Tax Valuation Adjustment) to enable quantification.