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FRM Part II · FRM Exam Part II · Counterparty Risk and Beyond

A bank's CVA desk is reviewing a trade with a counterparty. Which statement about debit valuation adjustment (DVA) is most accurate?

DVA captures the gain to the bank from its own potential default on liabilities in a derivative portfolio. When the bank's own credit spread widens, DVA rises and creates a gain in reported value. It is hard to hedge, and Basel III does not allow it as a capital offset.

  1. ADVA reflects the benefit to the bank from its own possible default, and when its own credit spread widens, DVA increases and produces a gain on the bank's reported valuationCorrect
  2. BDVA reflects the cost of the counterparty's default and rises when the counterparty's spread widens
  3. CDVA is always hedgeable directly by the bank by trading CDS on itself with no practical difficulty
  4. DDVA is fully recognised in Basel III regulatory capital as a positive offset to CVA

Explanation

DVA is the value of the bank's option to default on its negative exposure, so a widening own spread increases DVA and creates an accounting gain. It is counterintuitive and hard to hedge, since a bank cannot practically buy protection on itself. Basel III removes DVA from capital, so the last option is wrong.

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