Credit Risk Management Practice Exam

What is the primary difference between CVA and DVA calculations?

1. DVA calculates expected loss while CVA measures potential exposure.

2. DVA includes only the probability of a counterparty default, unlike CVA.

3. CVA focuses on market valuation while DVA incorporates negative expected exposure.

4. Both are calculated using the same exact formula and conditions.

The correct answer is: CVA focuses on market valuation while DVA incorporates negative expected exposure.

The correct answer highlights that CVA (Credit Valuation Adjustment) and DVA (Debit Valuation Adjustment) serve different roles in credit risk management, particularly regarding their focus on market impacts and expectations surrounding counterparty credit risk. CVA measures the potential loss that might occur due to the default of a counterparty, thereby focusing on the market valuation of potential credit risk over the life of an exposure. It incorporates pricing, market conditions, and the likelihood of default, which helps firms modify their valuations to account for the risk that the counterparty fails to fulfill their obligations. On the other hand, DVA accounts for the credit risk of the entity that has a liability, reflecting the potential financial benefit that could arise if the own creditworthiness deteriorates. This adjustment acknowledges that, should the entity default, the expected loss would be less than the nominal value of its liabilities. It incorporates the concept of negative expected exposure, thus allowing for a more nuanced understanding of net credit risk dynamics. The distinction in focus between CVA and DVA is fundamental to understanding how different types of credit risks are assessed and how they affect an organization’s financial position.