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

A bank's credit spread widens sharply because of concerns about its own creditworthiness, while the market value of its derivative contracts is unchanged. Under bilateral CVA accounting, what is the most likely effect on its reported earnings and the main risk management concern?

The bank would book a gain from higher DVA, because its own wider spread raises its default probability and lowers the fair value of what it owes. The gain is hard to realise or hedge, since a bank cannot buy CDS protection on itself.

  1. AA loss, because higher own spreads raise CVA on its assets
  2. BA gain from higher DVA, which is not realisable unless the bank defaults or restructures, and which complicates hedgingCorrect
  3. CNo effect, because DVA depends only on counterparty spreads
  4. DA gain that can be fully hedged by buying CDS protection on itself

Explanation

A wider own spread raises own default probability, increasing DVA and so lowering the liability's fair value, producing an accounting gain. This gain is counterintuitive, can only be realised through default or similar events, and the bank cannot directly buy CDS on itself, so hedging is difficult (proxy hedges are used).

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