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FRM Part II · FRM Exam Part II · Credit Value Adjustment

A bank calculates the fair value of an uncollateralised OTC derivative portfolio with a corporate client using bilateral CVA. Relative to a unilateral CVA calculation that considers only the counterparty's default, which statement best describes the effect of adding the DVA term?

Adding DVA reduces the total valuation adjustment. Bilateral CVA equals unilateral CVA minus DVA, because the bank benefits from not paying in full if it defaults while owing the counterparty. Recognising this gain offsets part of the CVA charge.

  1. AIt increases the value adjustment charged to the bank because the bank's own default risk adds to the total expected loss
  2. BIt reduces the total valuation charge because it recognises the benefit to the bank from its own possible default when it owes moneyCorrect
  3. CIt eliminates wrong-way risk because both parties' default probabilities are included
  4. DIt applies only to collateralised trades because own-default matters only when margin is posted

Explanation

Bilateral CVA equals unilateral CVA minus DVA. DVA is a gain from the bank's own default, since the bank would not pay in full when the portfolio has negative value to it. Including it therefore reduces the total charge. The option claiming it increases the charge has the sign wrong.

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