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FRM Part II · FRM Exam Part II · Derivatives

A bank's derivatives desk observes that the counterparty's credit spread widens sharply, while the bank's own credit spread is unchanged and exposures are unchanged. Under accounting-based bilateral valuation, what is the effect on the bank's reported position?

The bank's CVA rises because the counterparty's default probability implied by its wider spread is higher, with exposure unchanged. This lowers the fair value of the derivative assets and creates a reported mark-to-market loss. DVA is unaffected since it depends on the bank's own spread.

  1. ACVA increases, reducing the fair value of the derivative assets and generating a mark-to-market lossCorrect
  2. BCVA decreases, increasing earnings because default is more likely
  3. CDVA increases, producing a gain offsetting the counterparty's deterioration
  4. DNo change, because CVA depends only on the bank's own spread

Explanation

A wider counterparty spread implies higher default probability, so CVA rises for given positive exposure. This reduces fair value and creates a loss. DVA depends on the bank's own spread, which is unchanged, so it cannot offset the loss.

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