The required capital includes the capital for counterparty default, CVA capital, and capital under the leverage ratio. Its amount at each future date is estimated by simulating future values. This change of capital over time is the capital profile, and KVA is the sum of the profile multiplied by the hurdle rate1.

Consider a hypothetical example in which a trade needs 100 million yen of regulatory capital for one year and the hurdle rate is 10%. The capital cost for that year is 10 million yen. For a trade whose capital declines over time, the cost declines with the amount of capital.

At the time of a 2017 paper by the Bank of Japan's Institute for Monetary and Economic Studies, there was no market consensus on whether to include KVA in the price of a trade. Financial institutions that did not include it still used KVA as a profitability benchmark for trades1. Reducing CVA with an eligible hedge reduces CVA capital and therefore KVA as well, so including both CVA and KVA in a price can double count.

Notes

  1. 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 (pages 113–114) and Section 5 (3) (page 130) (in Japanese). Section 3.1 (page 10) of "KVA: Capital Valuation Adjustment" by Green, Kenyon, and Dennis (arXiv:1405.0515v3) describes the cost of capital as the return paid to shareholders on regulatory capital. ↩ ↩2