CVA, or Credit Valuation Adjustment, is calculated to account for the risk of counterparty default. In this case, the expected cost due to the counterparty defaulting can be quantified as 5% of the no-default value of the transactions adjusted for the 40% recovery rate, which equals $3 million ($100 million * 5% * (1 - 40%)). Similarly, DVA, or Debit Valuation Adjustment, represents the benefit to the bank if it defaults, calculated here as 3% of the no-default value adjusted for the recovery rate, equating to $1.8 million ($100 million * 3% * (1 - 40%)). Thus, the net effect is a decrease in the portfolio value by $1.2 million due to these adjustments.

A is incorrect because it incorrectly assigns the impacts of CVA and DVA to opposite effects.

B is incorrect because it misinterprets the impact of CVA as an increase and DVA as a decrease, which is contrary to their definitions and purposes.

D is incorrect because CVA and DVA do not cancel each other out—they address different risks and are not necessarily equal in magnitude.

Things to Remember

• CVA and DVA are crucial for adjusting the valuation of derivatives to reflect credit risk, ensuring that potential defaults by either party are considered in financial reporting and risk management.
• The calculation of CVA and DVA involves considering not just the probabilities of default but also the impact of recovery rates, highlighting the importance of robust recovery assumptions in risk modeling.
• Understanding the dual nature of CVA and DVA can aid in better risk management and more accurate pricing of derivatives by accounting for the interconnectedness of counterparty and own credit risk.