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

A bank's derivatives desk prices an uncollateralised interest rate swap with a corporate client. In addition to the risk-free value, the bank deducts an amount for the expected loss due to the client's possible default. Which valuation adjustment does this deduction represent?

The deduction is the credit valuation adjustment (CVA). It measures the expected loss from the counterparty defaulting while the bank is owed money, so it lowers the derivative's value. DVA relates to the bank's own default, FVA to funding costs, and KVA to capital costs.

  1. ACredit valuation adjustment (CVA)Correct
  2. BDebit valuation adjustment (DVA)
  3. CFunding valuation adjustment (FVA)
  4. DCapital valuation adjustment (KVA)

Explanation

CVA is the market value of expected loss from counterparty default on a positive-exposure portfolio, and it reduces the value of the derivative to the bank. DVA reflects the bank's own default and increases value, FVA covers funding costs, and KVA covers the cost of regulatory capital.

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