From FVA to KVA: including cost of capital in derivatives pricing
Youssef Elouerkhaoui presents a general derivatives pricing framework including cost of capital
With the increased capital requirements under Basel III, capital has become the main constraint for derivatives businesses; the profitability metric used has shifted from a net revenue or a market share measure to a return on equity (ROE) measure. ROE hurdle rates are now the de facto drivers of valuation (including both Basel III risk-weighted asset (RWAs) and supplementary leverage ratios (SLRs)). This is so critical to business profitability that banks are willing to take a profit and loss (P
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