29 November 2017
KVA calculations determine the lifetime costs of capital as part of the pricing of an OTC derivative trade. But what does that really mean?
Buffer for a rainy day
It is widely agreed that it makes sense to consider expected loss in pricing a derivative trade. Expected loss is the cost of doing business - we include it in trade pricing, call it CVA, and charge it up front. It’s covered in accounting standards as the proper way to price and represent the value of a trade.
In addition to expected loss, it’s also necessary to put money aside to ensure there are enough resources to survive an adverse scenario and cover unexpected loss, which can be thought of as a level of capital that is kept as a reserve. This level is defined as regulatory capital, and it ensures banks have enough margin in a bad economic scenario. This, again, makes perfect business sense. All businesses need to have some buffer for a rainy day.
Following the financial crisis, government authorities are concerned with survival of the banks. In fact, a national government needs to pick up the pieces if a bank in its jurisdiction should collapse. Therefore, it’s only fair that governments have some say in how large the buffer should be. That’s why we refer to the buffer as regulatory capital.
Two sides of the same coin
As explained, CVA and regulatory capital make sense for sound risk management. Valuations should be adjusted to compensate for expected credit loss up front and a buffer should be kept to cover losses in a stressed environment.
It could be argued that there is overlap between CVA and regulatory capital, but the two numbers play different roles. The CVA is part of pricing to the client, and the capital is the extra buffer required; You could say that they are two sides of the same coin. This has implications for how KVA is treated.
The jury’s out
Currently banks are not including KVA in accounting P&L and it’s not promoted in accounting standards. There are some good reasons why it should not be included in the fair value of a derivative. Capital can be thought of as the equity invested in the trading operation on which the investor expects a return. So the capital injection happens at the start of the trading operation and the trading activitiy aims to provide some reasonable return.
The counterargument is that it doesn’t matter what philosophical objections one may have against including KVA: if the market includes KVA in quoted prices, then it should be included in fair value by definition.
The jury’s still out on this issue, but the fact is that no bank is including KVA in their accounting P&L now. That’s not to say that it shouldn’t be calculated - KVA is vitally important for pricing of new derivative transactions.
A return on investment
Consider the balance sheet of a bank. (Figure 1). On the left side of the scale are assets that are acquired by issuing liabilities and own capital. Basel regulations tell how much capital is needed to be held on a balance sheet as a buffer given the riskiness of the assets.
The equity capital is made up of capital paid in by equity investors and retail earnings from previous years’ profit. Equity investors will require a return on the capital they have paid in.
When I enter into a new trade, I must ensure I have enough capital on the right side of the scale. If I don’t, I could ensure that the trade generates enough profit on Day 1 to cover my capital needs, but this would be very expensive. Instead, I could ask my equity investors for more capital. However, they will then expect the trade to generate enough return to make their investment worthwhile.
Cost of capital = equity investors’ expected return
To summarize: Owners require return on their capital investment. This expected return, sometimes called the hurdle rate, can vary. It represents the cost of equity capital, and hence the cost of regulatory capital. A market participant needs to ensure the profit of a trade can cover the cost of this capital over the lifetime of the trade, so a buffer should be charged upfront when a derivative is issued, and this upfront profit is KVA.
For more on KVA including an explanation of lifetime capital vs. point in time capital, sources of regulatory capital, the triCalculate approach to KVA, and more, view the Accelerated KVA webinar or contact us at [email protected].