Capital Valuation Adjustment and Funding Valuation Adjustment

TL;DR

This paper develops a mathematical framework for managing derivative portfolios in incomplete markets, focusing on optimal strategies for retained earnings to sustain dividends, considering the impact of XVA metrics like CVA, FVA, and KVA.

Contribution

It introduces a formalism for derivative portfolio management in incomplete markets, emphasizing optimal retained earnings strategies for sustainable dividends amidst XVA considerations.

Findings

Mathematical formalism for incomplete market derivatives management

Optimal retained earnings strategies for dividend sustainability

Integration of XVA metrics into portfolio management

Abstract

In the aftermath of the 2007 global financial crisis, banks started reflecting into derivative pricing the cost of capital and collateral funding through XVA metrics. Here XVA is a catch-all acronym whereby X is replaced by a letter such as C for credit, D for debt, F for funding, K for capital and so on, and VA stands for valuation adjustment. This behaviour is at odds with economies where markets for contingent claims are complete, whereby trades clear at fair valuations and the costs for capital and collateral are both irrelevant to investment decisions. In this paper, we set forth a mathematical formalism for derivative portfolio management in incomplete markets for banks. A particular emphasis is given to the problem of finding optimal strategies for retained earnings which ensure a sustainable dividend policy.