DVA for Assets

Chris Kenyon and Richard Kenyon

Contents

Introduction

Preface to Chapter 1

1.

Being Two-Faced over Counterparty Credit Risk

2.

Risky Funding: A Unified Framework for Counterparty and Liquidity Charges

3.

DVA for Assets

4.

Pricing CDSs’ Capital Relief

5.

The FVA Debate

6.

The FVA Debate: Reloaded

7.

Regulatory Costs Break Risk Neutrality

8.

Risk Neutrality Stays

9.

Regulatory Costs Remain

10.

Funding beyond Discounting: Collateral Agreements and Derivatives Pricing

11.

Cooking with Collateral

12.

Options for Collateral Options

13.

Partial Differential Equation Representations of Derivatives with Bilateral Counterparty Risk and Funding Costs

14.

In the Balance

15.

Funding Strategies, Funding Costs

16.

The Funding Invariance Principle

17.

Regulatory-Optimal Funding

18.

Close-Out Convention Tensions

19.

Funding, Collateral and Hedging: Arbitrage-Free Pricing with Credit, Collateral and Funding Costs

20.

Bilateral Counterparty Risk with Application to Credit Default Swaps

21.

KVA: Capital Valuation Adjustment by Replication

22.

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

23.

Warehousing Credit Risk: Pricing, Capital and Tax

24.

MVA by Replication and Regression

25.

Smoking Adjoints: Fast Evaluation of Monte Carlo Greeks

26.

Adjoint Greeks Made Easy

27.

Bounding Wrong-Way Risk in Measuring Counterparty Risk

28.

Wrong-Way Risk the Right Way: Accounting for Joint Defaults in CVA

29.

Backward Induction for Future Values

30.

A Non-Linear PDE for XVA by Forward Monte Carlo

31.

Efficient XVA Management: Pricing, Hedging and Allocation

32.

Accounting for KVA under IFRS 13

33.

FVA Accounting, Risk Management and Collateral Trading

34.

Derivatives Funding, Netting and Accounting

35.

Managing XVA in the Ring-Fenced Bank

36.

XVA: A Banking Supervisory Perspective

37.

An Annotated Bibliography of XVA

The effect of own-default on the valuation of liabilities and derivatives through the debit valuation adjustment (DVA) has been widely discussed in the pricing literature (Burgard and Kjaer 2011; Brigo 2011; Cesari et al 2009; Pallavicini et al 2011; Crépey 2015). However, the effect of own-default on assets has yet to attract similar attention (Kenyon and Stamm (2012) being an exception), although it is clear that default will affect any asset that depends on company existence or performance.

We provide a hedging strategy for pricing DVA on assets extending Burgard and Kjaer (2011), and consider an example, so-called goodwill, in depth. We calibrate our model to seven US banks over the crisis period of mid-2007 to 2011 and show how their reported profits would have changed if DVA on this asset, as well as liabilities, had been included. This effect is highly significant for at least four of the seven banks.

Financial Accounting Standard 157 (FAS 157) requires US banks to reflect their own potential non-performance, which includes creditworthiness, in the fair value of their liabilities (Financial Accounting Standards Board 2010). However, creditworthiness has effects on

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