Warehousing Credit Risk: Pricing, Capital and Tax
Introduction
Preface to Chapter 1
Being Two-Faced over Counterparty Credit Risk
Risky Funding: A Unified Framework for Counterparty and Liquidity Charges
DVA for Assets
Pricing CDSs’ Capital Relief
The FVA Debate
The FVA Debate: Reloaded
Regulatory Costs Break Risk Neutrality
Risk Neutrality Stays
Regulatory Costs Remain
Funding beyond Discounting: Collateral Agreements and Derivatives Pricing
Cooking with Collateral
Options for Collateral Options
Partial Differential Equation Representations of Derivatives with Bilateral Counterparty Risk and Funding Costs
In the Balance
Funding Strategies, Funding Costs
The Funding Invariance Principle
Regulatory-Optimal Funding
Close-Out Convention Tensions
Funding, Collateral and Hedging: Arbitrage-Free Pricing with Credit, Collateral and Funding Costs
Bilateral Counterparty Risk with Application to Credit Default Swaps
KVA: Capital Valuation Adjustment by Replication
From FVA to KVA: Including Cost of Capital in Derivatives Pricing
Warehousing Credit Risk: Pricing, Capital and Tax
MVA by Replication and Regression
Smoking Adjoints: Fast Evaluation of Monte Carlo Greeks
Adjoint Greeks Made Easy
Bounding Wrong-Way Risk in Measuring Counterparty Risk
Wrong-Way Risk the Right Way: Accounting for Joint Defaults in CVA
Backward Induction for Future Values
A Non-Linear PDE for XVA by Forward Monte Carlo
Efficient XVA Management: Pricing, Hedging and Allocation
Accounting for KVA under IFRS 13
FVA Accounting, Risk Management and Collateral Trading
Derivatives Funding, Netting and Accounting
Managing XVA in the Ring-Fenced Bank
XVA: A Banking Supervisory Perspective
An Annotated Bibliography of XVA
Credit valuation adjustments (CVAs) apply to all counterparties with derivatives transactions that are marked to market, that is, those in the trading book. For most banks only a subset of these counterparties have liquid credit default swap (CDS) contracts available for hedging default risk (the US dollar CDS market has only about 1,600 liquid contracts), so some credit risk is inevitably warehoused. Higher credit risk requires more capital. Open risk requires pricing in the physical measure rather than the risk-neutral measure.
Here, we extend the semi-replication approach in Burgard and Kjaer (2013) and Green et al (2014) to include counterparty credit risk warehousing and taxation of any resultant profit or loss. Thus, we introduce double semi-replication, that is, partial hedging of value jump on counterparty default and tax valuation adjustment (TVA). This value jump on counterparty default must be priced in, otherwise pricing will be inconsistent with the bank’s risk appetite. The market price of jump risk can be observed (Antje et al 2005; Berg 2010), but may be different from the bank’s.
Credit risk also affects the capital a bank is required to hold under Basel III
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