Financial Risk Manager Part 2

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Explanation:

Explanation

CVA (Credit Valuation Adjustment) represents the market value of counterparty credit risk - the risk that the counterparty will default and fail to make required payments. CVA increases when:

Counterparty credit spread widens (increased default probability)
Expected Positive Exposure (EPE) increases

DVA (Debit Valuation Adjustment) represents the institution's own credit risk - the benefit from the possibility that the institution itself might default. DVA decreases when:

The institution's own credit spread widens (increased default probability)
Expected Negative Exposure (ENE) remains unchanged or decreases

Analysis of the scenario:

Counterparty credit spread widens → Increases CVA
FI's credit spread widens → Decreases DVA (higher probability the FI will default, reducing the value of its liabilities)
EPE increases → Increases CVA (higher potential exposure to counterparty default)
ENE remains unchanged → No offsetting effect on DVA

Therefore, under these conditions:

CVA increases due to wider counterparty credit spread and higher EPE
DVA decreases due to wider FI credit spread

Correct answer: A - CVA increases; DVA decreases

Explanation:

Explanation

CVA (Credit Valuation Adjustment) represents the market value of counterparty credit risk - the risk that the counterparty will default and fail to make required payments. CVA increases when:

Counterparty credit spread widens (increased default probability)
Expected Positive Exposure (EPE) increases

DVA (Debit Valuation Adjustment) represents the institution's own credit risk - the benefit from the possibility that the institution itself might default. DVA decreases when:

The institution's own credit spread widens (increased default probability)
Expected Negative Exposure (ENE) remains unchanged or decreases

Analysis of the scenario:

Counterparty credit spread widens → Increases CVA
FI's credit spread widens → Decreases DVA (higher probability the FI will default, reducing the value of its liabilities)
EPE increases → Increases CVA (higher potential exposure to counterparty default)
ENE remains unchanged → No offsetting effect on DVA

Therefore, under these conditions:

CVA increases due to wider counterparty credit spread and higher EPE
DVA decreases due to wider FI credit spread

Correct answer: A - CVA increases; DVA decreases

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risk and the institution’s own credit risk, respectively. Under market stress, changes in credit spreads and exposures can impact these adjustments. During a market stress event:

Both the financial institution’s (FI) and its counterparty’s (CP) credit spreads widen significantly.

The FI’s Expected Positive Exposure (EPE) to the CP increases.

The FI’s Expected Negative Exposure (ENE) (the FI’s liability to the CP) remains unchanged.

How do the FI’s CVA and DVA change under these conditions?

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CVA increases; DVA decreases.

35.7%

CVA increases; DVA increases.

28.6%

CVA increases; DVA remains unchanged.

21.4%

CVA decreases; DVA increases.

14.3%