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

A bank calculates the fair value of an uncollateralized derivative portfolio with a corporate client. It then adjusts the risk-free value to reflect both the client's possible default and the bank's own possible default. Which expression correctly describes the bilateral adjustment to the risk-free value, from the bank's perspective?

The bilateral value equals the risk-free value minus CVA plus DVA. CVA is a deduction for the expected loss from the counterparty defaulting, while DVA is an addition reflecting the benefit of the bank possibly defaulting on amounts it owes.

  1. ARisk-free value minus CVA plus DVACorrect
  2. BRisk-free value plus CVA minus DVA
  3. CRisk-free value minus CVA minus DVA
  4. DRisk-free value plus CVA plus DVA

Explanation

CVA is the expected loss from the counterparty's default and reduces the portfolio value. DVA is the gain from the bank's own default, because the bank would not pay its full liability, and it increases the value. Hence value = risk-free value - CVA + DVA. The option with plus CVA gets the sign of the counterparty-risk charge wrong.

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