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FRM Part II · FRM Exam Part II · Derivatives

A risk manager notes that a bank's credit spread widened sharply during a stress period, and the bank's reported earnings rose due to DVA on its derivative portfolio. Which is the most appropriate risk management concern about this result?

The concern is that DVA gains from a widening of the bank's own credit spread are counterintuitive and hard to realise, because a bank cannot practically hedge its own default. Earnings rise as its creditworthiness deteriorates, which is why regulators exclude DVA from capital.

  1. ADVA gains are realisable only if the bank can hedge its own default, which is generally impractical, so the gains are counterintuitive and not easily monetisedCorrect
  2. BDVA gains show that the bank's counterparty credit exposure has fallen
  3. CDVA is always excluded from accounting fair value under IFRS
  4. DDVA gains indicate that the bank's CVA has become negative

Explanation

DVA rises when the bank's own spread widens because the value of its liabilities falls. This profit cannot readily be realised, since a bank cannot easily hedge its own default, and it creates perverse earnings. IFRS 13 includes own credit risk in fair value, so the exclusion option is wrong.

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