KVA: An Analysis of the Impact of Capital Costs on the Pricing of Interest Rate Swaps

Sebastian Devantier Becker & Mathias Øllegaard

Student thesis: Master thesis

Abstract

Until the most recent global financial crisis, which began in the summer of 2007, the market for interest rate swaps and other Over-the-Counter (OTC) derivatives had experienced tremendous growth. Financial innovation and deregulation of the financial sector globally enabled financial institutions to enter into trade agreements, which did not impose significant capital requirements upon the parties involved despite the risks they entailed. Derivatives in general, but especially CDO’s and CDS-contracts, which were used extensively in the period leading up to the crisis, were subject to significantly larger counterparty credit risks than what had been previously assumed in the market. As the crisis materialised, and the counterparty credit risks that played a major role therein became apparent, regulatory reform was implemented with higher capital requirements to ensure application of prudent capital policies across the banking industry.
The purpose of this thesis is to analyse the effect that the increased capital requirements for banks will have on their internal procedures as well as on their pricing of OTC derivatives, specifically concerning the capital pertaining to counterparty credit risk. In order to do so, the development in regulatory requirements for OTC derivatives is outlined, and the effect that these requirements have had on banks and credit institutions globally is highlighted. Furthermore, having introduced the concept of valuation adjustment, as well as a framework for computing credit exposure towards the counterparty on a given trade, a KVA (Capital Value Adjustment) charge is quantified based on a 10-year interest rate swap with a non-financial counterparty. Following the KVA calculation, a scenario analysis is performed to establish the effect of imposing changes on the calculation’s underlying base-case assumptions, illustrating the sensitivity of the results.
It is concluded that KVA in the example at hand constitutes a significant amount of the trade’s notional value, and due to the magnitude of the charge, a brief discussion of how credit institutions can handle KVA internally through a separate xVA desk is introduced. Finally, the implications of KVA and the overall regulatory requirements for the industry are discussed in order to speculate regarding the future of derivative trading given the current and expected future regulatory market conditions.

EducationsMSc in Finance and Accounting, (Graduate Programme) Final Thesis
LanguageDanish
Publication date2017
Number of pages121
SupervisorsSøren Plesner