Gap Risk KVA and Repo Pricing: An Economic Capital Approach in the Black-Scholes-Merton Framework

TL;DR

This paper extends the Black-Scholes-Merton model to incorporate gap risk and economic capital for repo pricing, deriving new valuation adjustments and practical pricing formulas.

Contribution

It introduces a reserve capital approach to model hedging errors and derives a new PDE with gap loss and capital charge terms for repo valuation.

Findings

A one-year equity repo can have a 50 basis points capital charge at zero haircut.

The break-even repo rate includes both funding costs and economic capital charges.

The model provides practical formulas for gap risk-adjusted repo pricing.

Abstract

Although not a formal pricing consideration, gap risk or hedging errors are the norm of derivatives businesses. Starting with the gap risk during a margin period of risk of a repurchase agreement (repo), this article extends the Black-Scholes-Merton option pricing framework by introducing a reserve capital approach to the hedging error's irreducible variability. An extended partial differential equation is derived with two new terms for expected gap loss and economic capital charge, leading to the gap risk economic value adjustment and capital valuation adjustment (KVA) respectively. Practical repo pricing formulae is obtained showing that the break-even repo rate decomposes into cost of fund and economic capital charge in KVA. At zero haircut, a one-year term repo on main equities could command a capital charge as large as 50 basis points for a 'BBB' rated borrower.