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

A bank's credit spread widens sharply during a market stress period because investors perceive it as riskier, while the bank's derivative positions and counterparties are unchanged. Under a bilateral valuation framework, what is the most likely effect on the bank's reported earnings related to its derivative liabilities?

The bank would book a gain from higher DVA. A wider own credit spread implies greater own default probability, reducing the fair value of what it owes, so liabilities fall in value and earnings rise, which is the counterintuitive feature often criticized.

  1. AA gain from higher DVA, because the fair value of its liabilities fallsCorrect
  2. BA loss from higher DVA, because its funding costs rise
  3. CNo effect, because DVA depends only on counterparty spreads
  4. DA gain from lower CVA, because its own default risk rises

Explanation

DVA rises with the bank's own default probability or spread. A higher own spread lowers the fair value of liabilities to counterparties, so the bank books a gain. This counterintuitive gain is a common criticism of DVA. CVA depends on the counterparty, not the bank's own spread.

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