Explanation:
Credit Value Adjustment (CVA) measures the value of counterparty credit risk (risk of the counterparty defaulting). Debt Value Adjustment (DVA) measures the value of an entity's own credit risk (risk of the entity itself defaulting).
A reduction in credit spreads for an entity reflects an improvement in its credit quality and a decrease in its probability of default.
Because both entities saw a decrease in their credit spreads, both the DVA and CVA for both parties in the swap contract will be lower compared to the initial terms.
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Q.4 In a recent transaction, Northern Star Bank (NSB) and Horizon Financial Group (HFG) entered into a 4-year interest rate swap. NSB agreed to pay HFG a fixed rate of 4.5% in exchange for 6-month SOFR plus a spread. Since the inception of the swap, both entities have experienced an improvement in their credit ratings. As a result, the credit spread for NSB has decreased from 90 bps to 40 bps, and the credit spread for HFG has decreased from 130 bps to 100 bps. Assuming the SOFR curve remains unchanged, which of the following statements is most likely to be correct if an identical 4-year swap was initiated today?
A
Since NSB's spread decreased more than HFG's spread, NSB's DVA will decrease and HFG's DVA will increase.
B
Since NSB's spread decreased more than HFG's spread, NSB's CVA will decrease and HFG's CVA will increase.
C
Since both entities' spreads decreased, the DVA and CVA on both sides of the contract will be lower.
D
Since both entities' spreads decreased, the DVA and CVA on both sides of the contract will be higher.