The value of the hurdle rate is an internal parameter that the board of directors sets in consultation with shareholders, and it may not be visible from outside. A close proxy is the return on equity (ROE) target a bank states, and the paper by Green and others uses 10% in its numerical examples1. The paper by Green and others describes the cost of capital as the return paid to shareholders on regulatory capital, in line with their decision to commit capital to derivatives trading. On this site, the rate applied to regulatory capital in KVA (the cost of capital in the papers by Green and others and by Saito) is called the hurdle rate.

Consider a hypothetical example in which a trade uses 100 million yen of regulatory capital and the hurdle rate is 10%. The capital cost is 10 million yen a year, and a return below that does not meet the benchmark. At a hurdle rate of 12%, the benchmark rises to 12 million yen.

At the time of a 2017 paper by the Bank of Japan's Institute for Monetary and Economic Studies, financial institutions that did not include KVA in the price of a trade still used KVA as a benchmark for the profitability of trades (the hurdle rate)2.

Notes

  1. Andrew Green, Chris Kenyon, and Chris Dennis, "KVA: Capital Valuation Adjustment" (arXiv:1405.0515v3), Section 3.1 (page 10). ↩

  2. Yuichi Saito, "金融規制の複合的影響を考慮したXVA" (XVA taking into account the combined effects of financial regulations), Kinyu Kenkyu, Institute for Monetary and Economic Studies, Bank of Japan (April 2017), Section 1 (page 113) (in Japanese). ↩