From FVA to KVA: Including Cost of Capital in Derivatives Pricing

Youssef Elouerkhaoui

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 assets (RWAs) and supplementary leverage ratios (SLRs)). This is so critical to business profitability that banks are willing to take a profit and loss (P&L) hit in order to hedge their regulatory capital and improve their ROE numbers. As trades stay on the book until maturity (or unwind) and capital is held accordingly, the lifetime cost of capital is an important concept that should be considered when pricing a trade. The valuation does not depend only on the spot RWA at trade inception, but should, in principle, depend on the whole forward RWA profile. Regulatory capital is a scarce resource, which is carefully allocated to the desk and strictly monitored, but not “priced-in” and reported in P&L. This is similar in many regards to the situation with credit valuation adjustment (CVA) in the period following the global financial crisis