Podcast: Mats Kjaer on how trades affect the balance sheet

Bloomberg quant has developed a balance-sheet model for XVA pricing

Mats Kjaer and Mauro Cesa

Photo: Marc Sargeant

In this Quantcast podcast, I talk to Mats Kjaer, head of quantitative XVA analytics at Bloomberg, about his latest work on capital valuation adjustment (KVA).

Kjaer is well known in the industry for having produced a number of highly cited papers on derivatives pricing and, in particular, on credit valuation adjustment (CVA) and funding valuation adjustment (FVA). One of these works led him and his co-author at the time, Christoph Burgard, to be named Risk’s quants of the year in 2015.

In the balance redux, Kjaer’s newly published paper, which will also appear in the November issue of Risk, presents a structural model developed on the dealer’s balance sheet.

The balance-sheet approach was largely inspired by a recent paper by Leif Andersen, Darrell Duffie and Yang Song titled Funding value adjustments, and it’s a clear departure from the semi-replication method Kjaer adopted in his most previous works. “I wanted to have something consistent for KVA to fit in with other XVA metrics, but I didn’t want to use semi-replication,” Kjaer explains.

The model, set up so that it considers equity financing, regulatory capital and hedging, was initially developed in a single-period setting and later extended to continuous time to make it applicable in practice. “I’m proud to say that the resulting work was released in production last month,” Kjaer reveals.

Investigating XVAs from a balance-sheet perspective also offered him some valuable insights. “I started off with the aim of looking at KVA,” says Kjaer, but he gained “more knowledge about the other valuation adjustments like FVA and CVA”.  

The method proves to be a comprehensive pricing tool, and quantifies the profitability of a trade from the viewpoint of the firm and that of the shareholder.

Furthermore, it aids in the visualisation of how much more expensive an unmargined swap is compared with a margined one, and shows how the credit rating of a counterparty affects the cost of the deal, making lower-rated firms less attractive.  

Index:

00:00 Intro

02:05 XVAs so far, a brief recap

05:52 What is In the balance, redux contributing

06:52 What are the results?

09:18 How banks can use the balance sheet approach to XVA

09:55 Impact of counterparty rating and margins on the valuation

11:20 Importance of continuous time models

12:20 Implementation

15:30 Future development of the model

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.