XVA Analysis From the Balance Sheet

Abstract

XVAs denote various counterparty risk related valuation adjustments that are applied to financial derivatives since the 2007--09 crisis. We root a cost-of-capital XVA strategy in a balance sheet perspective which is key in identifying the economic meaning of the XVA terms. Our approach is first detailed in a static setup that is solved explicitly. It is then plugged in the dynamic and trade incremental context of a real derivative banking portfolio. The corresponding cost-of-capital XVA strategy ensures to bank shareholders a submartingale equity process corresponding to a target hurdle rate on their capital at risk, consistently between and throughout deals. Set on a forward/backward SDE formulation, this strategy can be solved efficiently using GPU computing combined with deep learning regression methods in a whole bank balance sheet context. A numerical case study emphasizes the workability and added value of the ensuing pathwise XVA computations.