Warehousing credit risk: pricing, capital and tax
Warehousing of credit risk increases capital requirements and influences profit and loss. Profits are taxable and losses provide tax credits. Here, Chris Kenyon and Andrew Green extend the semi-replication approach of Burgard and Kjaer to formalise credit risk warehousing effects on pricing, including capital, and tax adjustments
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Credit valuation adjustments (CVA) 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$ 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
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