An indifference approach to the cost of capital constraints: KVA and beyond

TL;DR

This paper explores how capital constraints influence deal valuation in banking, proposing an indifference pricing framework to assess the impact of capital requirements and KVA on trading decisions from different stakeholder perspectives.

Contribution

It introduces an indifference pricing approach to evaluate capital constraints' effects on deal valuation, including linear, non-linear, and median-based optimization models.

Findings

Quantifies the impact of capital constraints on deal valuation.

Develops a unified framework for linear and non-linear valuation problems.

Analyzes the effect of median-based optimization on profit and loss assessment.

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.