Hull: Options, Futures, and Other Derivatives, Tenth Edition

Chapter 9: XVAs
Multiple Choice Test Bank: Questions with Answers

1. Which of the following is NOT a valuation adjustment

A. CVA
B. MVA
C. ZVA
D. KVA

Answer: C

CVA is credit valuation adjustments; MVA is margin valuation adjustment; KVA is capital
valuation adjustment. ZVA is not a valuation adjustment.

2. CVA stands for

A. Collateral valuation adjustment
B. Credit valuation adjustment
C. Credit valuation agreement
D. Collateral valuation agreement

Answer: B

CVA stands for credit value adjustment

3. DVA stands for

A. Debt valuation adjustment
B. Debt valuation agreement
C. Debt variation adjustment
D. Debit valuation agreement

Answer: A

DVA stands for debt (or debit) valuation adjustment

4. When a bank’s borrowing rate goes up, which of the following is true
A. DVA increases so that the bank’s profit goes down
B. DVA increases so that the bank’s profit goes up
C. DVA declines so that the bank’s profit goes down
D. DVA declines so that the bank’s profit goes up

Answer: B
 The bank is considered more likely to default and its DVA therefore increases. This increases its
profit because it is then considered more likely that it will default and not have to meet
derivatives obligations.

5. Which of the following is true

A. CVA and DVA can be calculated deal by deal
B. CVA and DVA must both be calculated for the whole portfolio a bank has with a
counterparty
C. CVA can be calculated deal by deal but DVA must be calculated for a portfolio
D. DVA can be calculated deal by deal but CVA must be calculated for a portfolio

Answer: B

Because of netting, all derivatives in a portfolio are considered to be a single derivative in the
event of a default. CVA which measures the cost of a counterparty default and DVA which
measures the benefit of the bank defaulting must therefore be calculated on a portfolio basis.

6. It is assumed that a company can default after one year or after two years. The probability of
default at each time is 1.5%. The present value of the expected loss to a bank on a derivatives
portfolio if the company defaults after one year is estimated to be $1 million. The present value
of the expected loss if it defaults after two years is estimated to be $2 million. Which of the
following is the bank’s CVA ?
A. $3,000,000
B. $300,000
C. $45,000
D. $150,000

Answer: C

The present value of the expected loss is 0.015×$1,000,000 + 0.015×$2,000,000 or $45,000.

This is the CVA.

7. A bank has three uncollateralized transactions with a counterparty worth +$10 million, −$20
million and +$25 million. A netting agreement is in place. What is the maximum loss if the
counterparty defaults today.
A. $15 million
B. $35 million
C. $20 million
D. Zero

Answer: A

The netting agreement means that the three transactions are considered to be a single
transaction. The net value of the transactions to the bank is 10−20+25 or $15 million. This is
the maximum amount that could be lost if the counterparty defaults today.
8. Which of the following involves most credit risk
A. Exchange trading
B. OTC trading with a central clearing party being used
C. OTC trading with bilateral clearing and collateral being posted
D. OTC trading with bilateral clearing and no collateral being posted

Answer: D

In the case of both exchange trading and trading using a CCP initial margin and variation margin
have to be posted so that the risk of a loss because of a default is low. Bilateral clearing usually
involves more credit risk than exchange/CCP trading and credit risk is greater when there is no
collateral agreement.

9. FVA is concerned with

A. The cost of funding initial margin
B. The cost of funding variation margin
C. The cost of regulatory capital
D. None of the above

Answer: B

FVA is concerned with the cost of funding variation margin

10. MVA is concerned with

A. The cost of funding initial margin
B. The cost of funding variation margin
C. The cost of regulatory capital
D. None of the above

Answer: A

MVA is concerned with the cost of funding initial margin

11. KVA is concerned with

A. The cost of funding initial margin
B. The cost of funding variation margin
C. The cost of regulatory capital
D. None of the above

Answer: C

KVA is concerned with the cost of regulatory capital

12. CVA is concerned with

A. The cost of funding initial margin
 B. The cost of funding variation margin
C. The cost of regulatory capital
D. None of the above

Answer: D

CVA is concerned with the cost of a counterparty default

13. Financial economics argues that

A. All investments by a company should earn the company’s weighted average cost of
capital
B. The required expected return on an investment is the average cost of debt
C. The required expected return on an investment increases with the riskiness of the
investment
D. The required expected return on an investment decreases with the riskiness of the
investment

Answer: C

The return required on an investment should in theory reflect its risk not how it is financed

14. Financial economics argues that as the percentage of equity in the capital structure increases
A. The required return on both equity and debt decrease
B. The required return on equity decreases and the required return on debt increases
C. The required return on equity increases and the required return on debt decreases
D. The required return on both equity and debt increase

Answer: A

As equity increases both the debt and equity become less risky to the investor

15. DVA for a bank is most dependent on

A. The default probabilities of the bank in future time periods
B. The default probabilities of the bank’s counterparties in future times periods
C. Both A and B
D. Neither A nor B

Answer: A

DVA is the cost to the counterparty (benefit to the bank) arising from the possibility of a default
by the bank. It is the bank’s default probabilities that are relevant

16. Which of the following is true

A. FVA is always positive
B. FVA is always negative
C. FVA for a transaction is initially zero
D. None of the above
 Answer: D

FVA can be positive or negative. For example the incremental FVA from the uncollateralized sale
of an option is negative whereas that from the purchase of an option is positive.

17. Prior to the credit crisis that started in 2007 which of the following was used by derivatives
traders for the discount rate when derivatives were valued
A. The Treasury rate
B. The LIBOR rate
C. The repo rate
D. The overnight indexed swap rate

Answer: B

Derivatives markets used LIBOR as the discount rate pre-crisis.

18. Since the credit crisis that started in 2007 which of the following have derivatives traders used
as the risk-free discount rate for collateralized transactions
A. The Treasury rate
B. The LIBOR rate
C. The repo rate
D. The overnight indexed swap rate

Answer: D

Derivatives markets have used the OIS rate as the discount rate for collateralized transactions
since the crisis.

19. Which of the following is true

A. OIS rates are less than the corresponding LIBOR/swap rates
B. OIS rates are greater than corresponding LIBOR/swap rates
C. OIS rates are sometimes greater and sometimes less than LIBOR/swap rates
D. OIS rates are equivalent to one-day LIBOR rates

Answer: A

OIS rates are less than LIBOR /swap rates when both have the same maturity.

20. Which of the following is approximately true

A. FVA can be calculated from the initial value of a derivative
B. FVA can be calculated on a transaction-by-transaction basis without considering the
whole portfolio of derivatives a dealer has with a counterparty
C. FVA should theoretically depend on a dealer’s funding cost
D. None of the above

Answer: B

The (positive or negative) funding arising from variation margin is additive across
transactions.