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Answer: Since both banks' spreads increased, the CVA on both sides of the contract will be higher.
C is correct. The lower credit qualities and increased credit spreads should result in higher DVA and CVA for both ADB and HIP. Thus, A, B and D are incorrect. **Detailed Explanation:** - **CVA (Credit Valuation Adjustment)**: Represents the market value of counterparty credit risk. When credit spreads increase (indicating higher default risk), CVA increases because the expected loss from counterparty default becomes higher. - **DVA (Debt Valuation Adjustment)**: Represents the market value of the firm's own credit risk. When a firm's credit spread increases, its DVA also increases because the firm's own default risk means it might not have to pay its obligations. - In this scenario: - HIP's credit spread increased from 36 bps to 144 bps (108 bps increase) - ADB's credit spread increased from 114 bps to 156 bps (42 bps increase) - Both banks experienced credit deterioration - Since both counterparties have higher credit risk, the CVA for both sides increases. The CVA that HIP calculates for ADB's risk increases, and the CVA that ADB calculates for HIP's risk also increases. - Options A and B are incorrect because they incorrectly assume that only one party's adjustment changes while the other decreases. - Option D is incorrect because DVA actually increases when credit spreads increase, not decreases.
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HIP Bank (HIP) often enters into interest rate swaps with ADB Banking Corporation (ADB) on terms that reflect appropriate counterparty risk. Earlier in the year, HIP and ADB entered into a 3-year swap in which ADB agreed to pay HIP a fixed rate of 5% in return for 6-month Secured Overnight Financing Rate (SOFR) plus a spread. Since the swap was entered into, both banks were downgraded. As a result of the rating changes, the credit spread for HIP has increased from 36 bps to 144 bps, while the credit spread for ADB has increased from 114 bps to 156 bps. Assuming no change in the SOFR curve, if an identical 3-year swap was entered into today, which of the following is the most likely to be correct?
A
Since HIP's spread increased more than ADB's spread, HIP's DVA will increase and ADB's DVA will decrease.
B
Since HIP's spread increased more than ADB's spread, HIP's CVA will increase and ADB's CVA will decrease.
C
Since both banks' spreads increased, the CVA on both sides of the contract will be higher.
D
Since both banks' spreads increased, the DVA on both sides of the contract will be lower.