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

A risk manager debates whether a bank should include DVA in the price of derivatives it trades. Which statement best describes a widely cited concern about recognising DVA?

The main concern is that DVA produces a gain when the bank's own creditworthiness deteriorates, which is counterintuitive and hard to monetise or hedge without the bank defaulting. For this reason regulators exclude DVA from regulatory capital measures.

  1. AA deterioration in the bank's own credit quality produces an accounting gain, which cannot be easily monetised without defaulting or hedgingCorrect
  2. BDVA increases when the bank's credit spread narrows, which creates volatile losses
  3. CDVA is mandatory for regulatory capital under Basel III CVA risk calculations
  4. DDVA only affects collateralised trades so it has no P&L impact

Explanation

DVA rises when the bank's own spread widens, giving a paper gain on a worsening credit position that is hard to realise or hedge. Basel III excludes DVA from regulatory capital, so the third option is wrong, and the spread-narrowing direction in the second is reversed.

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