KVA from the Beginning

16 Pages Posted: 18 Sep 2017 Last revised: 6 Oct 2019

Date Written: July 10, 2017

Abstract

Understanding the interaction between a new derivative, its financing and the wider balance sheet during pricing is critical for dealer profitability. For this purpose we extend a single period structural balance sheet model developed in Andersen, Duffie and Song to include equity financing before deriving consistent firm and shareholder break even prices. The former is given by the risk neutral expectation of the derivative cash flow in all scenarios including dealer default, discounted at the risk-free rate. The latter on the other hand is given by a dealer survival measure expectation of the derivative cash flow, including at counterparty default, discounted at the dealer weighted average rate of capital. This discounting rate is partially determined by the minimum amount to equity funding required by regulators. We next show how the shareholder break even price can be split into funding and capital valuation adjustments. All results are valid whether the dealer chooses to hedge the derivative or not.

Keywords: Regulatory capital, Valuation adjustments, Balance sheet modelling, indifference pricing

JEL Classification: G13

Suggested Citation

Kjaer, Mats, KVA from the Beginning (July 10, 2017). Available at SSRN: https://ssrn.com/abstract=3036826 or http://dx.doi.org/10.2139/ssrn.3036826

Mats Kjaer (Contact Author)

Bloomberg L.P. ( email )

39-45 Finsbury Square
City Gate House
London, EC2A 1PQ
United Kingdom

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