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

A risk manager at a bank notes that the bank's own credit spread widened sharply during a market stress, and the bank's reported derivative liabilities fell in fair value because of DVA. Which is the most appropriate risk management concern about this result?

The main concern is that a DVA gain arises from the bank's own deteriorating credit and cannot be realised or hedged except through default or restructuring. It makes earnings perverse, so Basel III removes such gains from common equity capital.

  1. AThe gain is unhedgeable in practice and does not represent cash the bank can realise unless it defaults or restructures, so it distorts earnings and regulatory capitalCorrect
  2. BDVA gains always reflect a genuine improvement in the bank's creditworthiness
  3. CDVA should be added to regulatory capital because it increases loss-absorbing capacity
  4. DDVA is symmetric with CVA, so the gain is fully offset by a hedge in the counterparty's books

Explanation

A DVA gain arises when the bank's own credit worsens, which is perverse and cannot be readily monetised or hedged without the bank's default. Hence Basel III removes DVA gains from CET1 capital. The other options misstate the nature of DVA.

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