From Credit Valuation Adjustments to Credit Capital Commitments

Abstract

We argue that capital requirements are needed to cover unexpected losses arising in incomplete markets. After observing that a complete market is an inappropriate context for answering such questions we turn to a theory of capital requirements developed for an incomplete markets economy where the law of one price is replaced by the law of two prices. We follow Carr, Madan and Vicente Alvarez (2011) in defining capital requirements and apply these methods to the problems of cross default exposures. We contend that credit valuation adjustments, being based on fundamentally contradictory principles fall short of what is required. We replace these computations by direct computations of credit capital commitments necessitated by credit exposures that we term a CCC theory. A variance swap example illustrates our CCC computations.