Financial Risk Manager Part 2

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Explanation:

Option B is false (and therefore the correct answer). Stress testing BCVA involves stressing the underlying market risk factors that drive the future Expected Exposures (EE) and Probabilities of Default (PD). Replacing projected expected exposures with observable current exposures would defeat the purpose of estimating future counterparty risk and would fail to properly evaluate the risk over the life of the derivatives.

Why the other options are true statements:

Option A: In the BCVA framework, the bank receives a DVA benefit based on its own probability of default (it is effectively short its own credit). If the bank's own credit quality improves, its probability of default falls, meaning the DVA benefit falls, resulting in a mark-to-market loss on the BCVA.
Option C: Unilateral CVA assumes the institution is default-free. BCVA explicitly accounts for the survival probabilities of both parties to adjust for the first-to-default effect.
Option D: CVA transforms Counterparty Credit Risk (CCR) into a derivative pricing adjustment (a market value), allowing the volatility of CVA to be aggregated and stressed alongside traditional market risks within the firm's market risk framework.

Explanation:

Why the other options are true statements:

Option A: In the BCVA framework, the bank receives a DVA benefit based on its own probability of default (it is effectively short its own credit). If the bank's own credit quality improves, its probability of default falls, meaning the DVA benefit falls, resulting in a mark-to-market loss on the BCVA.
Option C: Unilateral CVA assumes the institution is default-free. BCVA explicitly accounts for the survival probabilities of both parties to adjust for the first-to-default effect.
Option D: CVA transforms Counterparty Credit Risk (CCR) into a derivative pricing adjustment (a market value), allowing the volatility of CVA to be aggregated and stressed alongside traditional market risks within the firm's market risk framework.

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708.3. The formula below is given by Lynch as the bilateral credit value adjustment (bilateral CVA; although the typo is corrected where he means to include NEE rather than duplicate EE):
$BCVA = \sum_{n=1}^{N} LGD_n^* \cdot \sum_{j=1}^{T} EE_n^(t_j) \cdot q_n^(t_{j-1}, t_j) \cdot S_i^(t_{j-1}) \\ - \sum_{n=1}^{N} LGD_i^ \cdot \sum_{j=1}^{T} NEE_n^(t_j) \cdot q_i^(t_{n-1}, t_j) \cdot S_n^*(t_{j-1})$
Acme Bank is applying this BCVA formula in regard to measuring credit counterparty exposure to its counterparty, and, further, Acme will stress test this BCVA. Each of the following statements is true EXCEPT, which is false?

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Last updated: July 5, 2026 at 07:03

If Acme's own credit quality improves, Acme experiences a loss on the BCVA

For stress testing this BCVA, subjective expected exposures should be replaced by observable current exposures