Introduction to KVA

How did KVA emerge?

Before the financial crisis, capital requirements for derivatives were very light, with the main rule being Counterparty Credit Risk (CCR), which treated capital being similar to a loan to the countparty in an amount equivalent to the current exposure of the derivative. This caused two issues:

Firstly, as credit ratings are used to determine CCR capital, and CDS spreads used in CVA (the pricing of credit risk on derivatives) valuations, there were billions in CVA losses in the crisis as CDS spreads widened massively, but ratings didn’t move. 

Secondly, the calculation of CCR only looks at the current exposure of a derivative, whereas CVA charges are driven by the exposure profile. 

These two issues lead to a cyclical movement in capital. I.e. the economy does well, CCR and CVA are low. In crisis times, CVA increases, then finally capital increases as counterparties are downgraded. This then lead to significant capital requirements on firms at the same time they were struggling with CVA losses. 

Basel III provided a buffer for CVA losses as well as realised counterparty losses with the aim of being less cyclical. CCR remained and firms could move to a standardised or advanced CVA model. 

Why did Basel III cause KVA?

The introduction of Basel III significantly increased the amount of capital required to be held, especially for uncollateralised derivative trades. 

Many firms left the industry, but for the firms still involved the requirement to hold significantly more collateral resulted in lower returns on capital and firms realised the cost had to be reflected in both pricing and trading.

There were two outcomes from this: 

1. Clearing became more common due to beneficial capital treatment. 
   For trades requiring higher capital, banks priced in a mark-up at the time of execution.
2. Estimating this cost of capital over the life of a trade became known as KVA, the expected value of the cost of capital. 

How is KVA calculated?

Calculating KVA is as much of an art as it is a science. Many transactions may be unwound or restructured during their lifetime. This is especially true for loan hedges. How much will economic hedges for CVA benefit or hinder the regulatory calculation? This cannot be answered precisely and it can have a significant impact on return metrics. Also, capital management is not as dynamic as funding. 

KVA is used as a guide for firms when they are pricing up new transactions as to how much mark-up to put on a trade so that they are not deploying capital at too cheap a rate.  It is not held as an accounting adjustment, and this creates a potential mismatch between when revenues are declared (usually on day one due to mark-to-market accounting) and the capital that is held over the life of a transaction.

KVA is at the cutting edge of pricing derivative transactions, and there is still a lot of discussion around best practice and how it will be developed going forward.