Published: March 2016
Global Valuation provides the processing power to now correctly model the significant impact of capital and collateral on the true cost of funding.
In the aftermath of the 2007 global financial crisis, banks started using XVA metrics to reflect the cost of capital and collateral funding into derivative pricing. XVA is a catch-all acronym whereby X is replaced by a letter such as C for credit, D for debt, F for funding, K for capital and so on, and VA stands for valuation adjustment.
This behaviour is at odds with economies where markets for contingent claims are complete, whereby trades clear at fair valuations and the costs for capital and collateral are both irrelevant to investment decisions.
In this paper, we set forth a mathematical formalism for derivative portfolio management in incomplete markets for banks. A particular emphasis is given to the problem of finding optimal strategies for retained earnings which ensure a sustainable dividend policy.