Podcast: Matthias Arnsdorf on a new – and cheaper – KVA

JP Morgan quant proposes an alternative approach, anchored by a dealer’s default rate, rather than its return on equity

Every time a bank executes a derivatives trade there is – in theory – some incremental impact on its regulatory capital requirement, and a cost to shareholders. This cost can be reflected in the spread charged for the trade, known as a capital valuation adjustment, or KVA.

This is a complex calculation, and according to Matthias Arnsdorf – global head of counterparty credit risk quant research at JP Morgan, and our guest for this Quantcast – traditional approaches have made a mistake in anchoring the adjustment to a bank’s return on equity. In a paper published this month on Risk.net, he introduces a quantity that is instead found to be proportional to the default rate of the firm, rather than its ROE.

Arnsdorf derives KVA from first principles. He represents each trade as a transfer of wealth between shareholders and bondholders – so, as the balance between the firm’s equity and bonds varies, the value to the shareholder does as well. The quantity he introduces, KVA2, captures such variation.

The KVA resulting from Arnsdorf’s recipe may be tens of times lower than that calculated with the standard approach. This will be instantly appealing to a lot of dealers, but the idea is in its infancy and its viability is still to be tested.

To hear the full interview, listen in the player above, or download. Future podcasts in our Quantcast series will be uploaded to Risk.net. You can also visit the main page here to access all tracks, or go to the iTunes store or Google Podcasts to listen and subscribe.

Index

00:00 Intro

01:20 What KVA is, and why it matters

05:30 Issues with the standard approach to KVA

11:15 Transfer of wealth between shareholders and bondholders

14:45 Comparison with Kjaer and Andersen’s approaches

19:50 The appetite of banks for KVA2 and potential regulatory reservations