Abstract
The capital valuation adjustment (KVA) is one of the more recent additions to the XVA family. In this article, we examine two key questions surrounding KVA: What is the correct return on equity (RoE) that should be assigned to a derivatives portfolio and what impact should changes in a firm's equity capital levels or leverage have on valuation? Addressing these questions leads naturally to the definition of two distinct valuation adjustments we refer to as KVA1 and KVA2. KVA1 is a reflection of unpriced risk which can be present in incomplete markets. At the firm level it is proportional to the RoE but insensitive to changes in leverage. KVA2 on the other hand represents the shareholder cost of changes in leverage and is proportional to capital levels. However, the effective rate on the capital is the form's junior funding rate and not the RoE. This article is a high-level summary of two more detailed recent papers by the author.
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