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

A dealer bank reports a gain when its own credit spread widens because the fair value of its derivative liabilities falls through a higher debit valuation adjustment (DVA). Which criticism of this treatment is most valid for risk management?

The main criticism is that DVA produces profit when the bank's own creditworthiness deteriorates, and that gain is hard to realise unless the bank defaults or hedges via its own debt. This makes earnings counterintuitive and pro-cyclical.

  1. AThe gain cannot be monetised without the bank defaulting or hedging through its own credit, so it makes earnings pro-cyclical and misleadingCorrect
  2. BDVA always equals CVA, so the effects net to zero
  3. CDVA is never permitted in any accounting framework
  4. DDVA reduces the counterparty's exposure to the bank

Explanation

A wider own spread raises DVA and creates a profit, although the bank is in worse health. The gain is hard to realise short of default or hedging by trading own debt, so it is a counterintuitive and pro-cyclical earnings effect. DVA does not equal CVA in general, and it is allowed under fair value accounting.

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