KVA, What is the Hurdle? A Study of Whether Capital Cost Should Be Adopted Into Fair Value Accounting

Abstract

In the years 2008-2013 several corporates entered interest rate swaps which have become an extreme liability in their accounting due to the current interest rate level. The banks are regulatorily restricted to keep capital to prevent insolvency in the event of default of the corporates. The banks do however not include a valuation adjustment for holding capital, KVA, in their mark-to-market accounting and the fair value reported to the corporates. This thesis aims to examine if KVA should be included in the mark-to-market accounting, which relief some of the corporate’s liabilities. First, the thesis describes the regulatory framework for banks and how KVA is derived through a semi-replicating model framework. It then goes on to implement KVA on two concrete interest rate swaps to quantify the size of KVA and enlighten its significance. The thesis finds that KVA is an important valuation adjustment as it can be twice the size of CVA, hence it can reduce the value of the swap and the corporate’s liabilities significantly. It is then discussed why KVA is not included in the mark-to-market value. The thesis consults with three respondents from the danish banking industry, and finds that the common arguments for excluding it accounting wise attributes to its size; subjectivity; that it cannot be hedged; and that it should be managed as profit. Counterarguments are given against the validity of these objections. A fifth argument based on growing academic literature identifies KVA as a wealth transfer between stakeholders and creditors, which can justify why it is not market practice to include KVA in the fair value. The thesis, however, concludes that KVA should be included in the fair value, when pricing derivatives because it is clear from legislation based upon IFRS 13 and it creates consistency between price and valuation.