Chapter 7: KVA and Other Adjustments and Costs

Whereas prior to 2008, derivatives pricing was very much based on the concept of efficient markets (i.e. ability to borrow and lend large amounts at the same rate, existence of deep markets which allows one to trade in size without affecting market prices) and costs were seen as an afterthought; it has now been well established that pricing must reflect a lot of the costs associated with maintaining the position (i.e. CVA, DVA, FVA and MVA). Indeed, markets have become less efficient since 2008 (i.e. scarcity of capital leading to a high cost in funding, reduction in market depth as players exit unprofitable businesses and higher capital charges take hold), so that such adjustments become more significant…