Handling model risk with XVAs

Abstract

In this paper we revisit Burnett (2021) \& Burnett and Williams (2021)'s notion of hedging valuation adjustment (HVA), originally intended to deal with dynamic hedging frictions such as transaction costs, in the direction of model risk. The corresponding HVA reconciles a global fair valuation model with the local models used by the different desks of the bank. Model risk and dynamic hedging frictions indeed deserve a reserve, but a risk-adjusted one, so not only an HVA, but also a contribution to the KVA of the bank. The orders of magnitude of the effects involved suggest that local models should not so much be managed via reserves, as excluded altogether.

References in corpus (4)

• Sensitivity analysis of Wasserstein distributionally robust optimization problems
• Statistical Learning of Value-at-Risk and Expected Shortfall
• Distributionally Robust XVA via Wasserstein Distance Part 2: Wrong Way Funding Risk
• The Recalibration Conundrum: Hedging Valuation Adjustment for Callable Claims