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

A risk committee debates whether to include DVA in the price quoted for a new uncollateralised derivative. Which argument is the strongest criticism of relying on DVA when pricing and managing risk?

The strongest criticism is that DVA's benefit comes only from the bank's own possible default, so it cannot be realised or reliably hedged while the bank is a going concern, and its gains rise as the bank's credit worsens.

  1. ADVA is mathematically undefined when the counterparty has a high default probability
  2. BDVA creates symmetric pricing agreement, but its benefit arises only in the bank's own default, so it cannot be monetised as a going concernCorrect
  3. CDVA increases regulatory capital under Basel III CVA rules
  4. DDVA double-counts the counterparty's recovery rate

Explanation

The key criticism is that DVA gains reflect the bank's own deterioration and can be realised only if the bank defaults, or by closing out. Basel III in fact excludes DVA from regulatory capital recognition, rather than increasing capital, so the capital option is wrong.

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