Credit Risk Management Practice Exam

How is DVA calculated?

1. DVA = −LGDI × ∑m NEE (ti) × PDI (ti−1, ti)

2. DVA = LGDC × ∑m EE (ti) × PDC (ti−1, ti)

3. DVA = CE × EPE

4. DVA = EAD × LR

The correct answer is: DVA = −LGDI × ∑m NEE (ti) × PDI (ti−1, ti)

The calculation of DVA, or the Debit Valuation Adjustment, is crucial in assessing the credit risk of derivatives. The formula includes the use of LGDI, which stands for the loss given default of the counterparty, and the expected exposure over time, represented by the sum of NEE, or net expected exposures, across different time intervals. PDI refers to the probability of default of the counterparty in those intervals, specifically from ti-1 to ti. This relationship reflects the fact that DVA accounts for the reduction in the value of a company’s credit risk due to its own potential default. When a company defaults, the value of its liabilities decreases and thus has an effect on the overall credit risk assessment of derivatives. The use of these components in the formula captures the interplay between exposure, default probabilities, and loss given default, allowing for a more accurate reflection of the risk involved. This understanding also shows the limitations in the other formulas provided. The second option uses LGDC and EE, which are centered around the creditworthiness of the company rather than the counterparty. The third option equates DVA to expected positive exposure without consideration of the counterparty's credit quality, which is essential for DVA. Lastly, the fourth formula