Gap risk KVA and repo pricing
Starting with the unhedgeable gap risk during a margin period of risk, Wujiang Lou introduces a reserve capital approach to the hedging error, defines economic capital and builds cost of capital into the Black-Scholes-Merton pricing framework. Thus formulated, capital valuation adjustment is found to dominate repurchase agreement pricing and valuation
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The theory of option pricing derives from the construction of a trading portfolio in the underlying stock and money market investment. It is constructed such that the option is dynamically hedged. A short call option on a stock modelled after a geometric Brownian motion, for example, can be self-financed and replicated perfectly so there is no hedging error. The option and its hedging portfolio, therefore, contribute zero market risk capital. When the stock price is
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