An Indifference Approach to the Cost of Capital Constraints: KVA and Beyond

15 Pages Posted: 21 Aug 2017

See all articles by Damiano Brigo

Damiano Brigo

Imperial College London - Department of Mathematics

Marco Francischello

Imperial College London - Department of Mathematics

Andrea Pallavicini

Banca IMI; Imperial College London - Department of Mathematics

Date Written: August 17, 2017

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.

Keywords: KVA, Capital Constraints, Indifference Pricing, RAROC

JEL Classification: C61, C44, G13, G31

Suggested Citation

Brigo, Damiano and Francischello, Marco and Pallavicini, Andrea, An Indifference Approach to the Cost of Capital Constraints: KVA and Beyond (August 17, 2017). Available at SSRN: https://ssrn.com/abstract=3022805 or http://dx.doi.org/10.2139/ssrn.3022805

Damiano Brigo

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.imperial.ac.uk/people/damiano.brigo

Marco Francischello (Contact Author)

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
Imperial College
LONDON, SW7 2AZ
United Kingdom

Andrea Pallavicini

Banca IMI ( email )

Largo Mattioli 3
Milan, MI 20121
Italy
+39 02 7261 (Phone)

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

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