Explanation:
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
Ultimate access to all questions.
No comments yet.
Q.6217 Bank Z is analyzing the impact of credit risk on its derivatives portfolio. The bank calculates Credit Valuation Adjustment (CVA) and Debit Valuation Adjustment (DVA) to assess the expected costs due to the possibility of default by either the counterparty or the bank itself over the duration of the derivatives contracts. Assume Bank Z has a portfolio with a no-default value of outstanding derivatives transactions of $100 million, an expected recovery rate (R) of 40%, and has calculated a total risk-neutral default probability for the counterparty and the bank over the life of the transactions at 5% and 3% respectively. Using this information, which of the following statements best quantifies the financial impact of the CVA and DVA on the value of the derivatives portfolio?
A
The CVA and DVA reduce the portfolio value by $3 million and increase it by $1.8 million, respectively, resulting in a net decrease of $1.2 million.
B
The CVA increases the portfolio value by $5 million due to expected recovery, while DVA decreases it by $3 million, netting an increase of $2 million.
C
The CVA decreases the portfolio value by $3 million due to counterparty risk, while DVA increases it by $1.8 million due to the bank's own default risk, resulting in a net portfolio value decrease of $1.2 million.
D
The CVA and DVA are equal and opposite, effectively nullifying each other and leaving the portfolio value unchanged at $100 million.