Chapter 9

XVAs

Practice Questions
Problem 9.1.
Explain what CVA and DVA measure?

CVA measures the cost to a derivatives market participant arising from the possibility of a
default by a counterparty. DVA measures the benefit to the market participant (equals cost to the
counterparty) arising from the possibility that the market participant might itself default.

Problem 9.2.
If the market considers that the default probability for a bank has increased, what
happens to its DVA? What happens to the income it reports?

If the market considers that a bank has become less creditworthy so that it is more likely to
default, its DVA will increase. This will lead to an increase in its income and its equity. This
seems paradoxical. How can there be an automatic increase to a bank’s income and its equity
when it becomes less creditworthy? The answer is as follows. When a bank becomes less
creditworthy, there is an increase in the expected benefit to the bank from the fact that it might
default on outstanding derivatives transactions. In the third quarter of 2011, the credit spreads of
Wells Fargo, JPMorgan, Citigroup, Bank of America, and Morgan Stanley increased by 63, 81,
179, 266, and 328 basis points, respectively. As a result, these banks reported DVA gains that
tended to swamp other income statement items. DVA gains and losses are approved by
accounting bodies, but have now been excluded from the definition of common equity in
determining regulatory capital.

Problem 9.3.
"The impact of DVA on earnings volatility is generally greater than that of CVA." Explain this
statement.

The DVA for a bank depends on a single credit spread (its own) whereas CVA depends on the
credit spread of all the bank’s counterparties. On any given day some counterparty spreads can
be expected to go up while others go down so that there are some offsets. DVA can therefore be
expected to be more volatile.

Problem 9.4.
Explain what MVA and FVA measure.

MVA or margin valuation adjustment measures the cost of initial margin. FVA or funding
valuation adjustment measures the cost of variation margin.
Problem 9.5.
Explain the difference between the views of financial economists and most practitioners on how
MVA and FVA should be calculated.

Financial economists argue that the cost of funding margin should be related to its risk (which is
fairly low). Most practitioners consider that the cost should be the bank’s average funding cost.

Problem 9.6.
Explain what KVA measures.

KVA measure the cost of the regulatory capital required for trades.

Problem 9.7.
Explain the difference between the views of financial economists and most practitioners on how
KVA should be calculated.

Many practitioners calculate KVA by arguing that there is a cost if a bank does something that
requires additional regulatory capital and that the incremental return on the regulatory capital
should be at least the return required by shareholders. A financial economist would argue against
this if the project is less risky than the average project undertaken by the bank because the
project will lower the average risk of the bank and therefore lower the return required by equity
holders.

Problem 9.8.
Explain why FVA can be calculated for a transaction without considering the portfolio to which
the transaction belongs, but that the same is not true of MVA.

FVA is concerned with variation margin. The variation margin for a portfolio is the sum of the
variation margins for the transactions in the portfolio. (As indicated in footnote 13 of Chapter 9
this is only approximately true when the impact of defaults on funding is considered.) MVA is
concerned with initial margin which (at least in the case of CCPs) is calculated at the portfolio
level. (Note: The standard regulatory approach to setting initial margin for bilaterally cleared
derivatives does not permit netting. However, the industry has come up with SIMM, Standard
Initial Margin Model, which does allow netting.)

Problem 9.9
Suppose that a bank buys an option from a client. The option is uncollateralized and there are
no other transactions outstanding with the client. The expected values of the option at the mid
point of years 1, 2, and 3 are 6, 5, and 4. The probability of the counterparty defaulting in each
of the three years is 3%. The probability of the bank defaulting in each of the three years is 2%.
What is the bank's CVA and DVA for the transaction. Assume no recovery in the event of default
and zero interest rates.

CVA = 0.03 × 6 + 0.03 × 5 + 0.03 × 4 = 0.45

The DVA is zero because the value of the transaction to the counterparty is negative.
Problem 9.10.
Explain how the “cure period” is used in the calculation of CVA.

A company is assumed to stop posting collateral for a period before it defaults. The length of this
period is the cure period.

Problem 9.11.
A company is trying to decide between issuing debt and equity to fulfill a funding need. What in
theory should happen to the return required by equity holders if it chooses (a) debt and (b)
equity.

If it chooses debt, the equity becomes more risky and the expected return of equity holders
increases. If it chooses equity, the equity becomes less risky and the expected return required by
equity holders goes down.

Problem 9.12.
Explain the meaning of “netting.” Suppose no collateral is posted. Why does a netting
agreement usually reduce credit risks to both sides. Under what circumstances does netting have
no effect on credit risk.

A netting agreement states that all transactions are considered to be a single transaction in the
event of a default. Transactions with a positive value are netted against transactions with a
negative value. This usually reduces exposure because a company cannot cherry pick which
transactions it will default on. Credit risk not affected by netting when all transactions will have
a positive value at all times or when all transactions have a negative value at all times.

Further Questions

Problem 9.13.
The average funding cost for a company is 5% per annum when the risk-free rate is 3%.
The company is currently undertaking projects worth $9 million. It plans to increase its
size by undertaking $1 million of risk-free projects. What would you expect to happen to
its average funding cost.

The average funding cost should come down. The company will become less risky. Its average
funding cost should be a weighted average of 5% for the old projects and 3% for the new ones.
This is 0.9×5%+0.1×3% or 4.8%.

Problem 9.14.
Suppose that, for a particular three-year derivative entered into by a bank, two outcomes, A and
B, are equally likely. Under outcome A, the values of the derivative at the mid point of the first,
second, and third years are 3, 5, and 7, respectively. Under outcome B, the values of the
derivative at the mid points of the first, second, and third years are −2, −4, and −6. The
probability of the counterparty defaulting each year is 1% and the probability of the bank
defaulting each year is 0.5%. Calculate the bank's CVA and DVA. Assume that interest rates are
zero, no collateral is posted, and there are no other transactions between the two parties.
The expected exposures of the bank at the mid points of the first second and third years are 0.5×3
= 1.5, 0.5×5 = 2.5, and 0.5×7 = 3.5. Hence
CVA = 0.01 × 1.5 + 0.01 × 2.5 + 0.01 × 3.5 = 0.075

The expected exposures of the counterparty at the mid points of the first second and third years
are 0.5×2 = 1, 0.5×4 = 2, and 0.5×6 = 3. Hence
DVA=0.005×1+0.005×2+0.005×3 = 0.03