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FRM Part II · FRM Exam Part II

Credit Value Adjustment for FRM Part II

Credit value adjustment (CVA) is the market value of counterparty credit risk on a derivative portfolio. Unilateral CVA is roughly the sum of expected exposure × default probability × loss given default, discounted. To solve questions, build the exposure profile, apply netting and collateral, then weight by default probabilities.

What this chapter covers

This chapter is about pricing and managing the risk that a derivative counterparty defaults before it pays what it owes. You start with exposure: how much you could lose, and when. You then see how netting and collateral shrink that exposure. Finally you convert exposure into a price, the CVA, and look at the adjustments around it.

The chapter has a clear chain. Exposure metrics feed the CVA formula. Netting and collateral change the exposure that goes into it. Bilateral CVA adds your own default through DVA. Wrong-way risk breaks the simple assumption that exposure and default are independent. Hedging, capital and funding adjustments show how banks deal with all this in practice.

It connects directly to the rest of Part II. Credit risk questions use the same default probability, loss given default and recovery ideas. Market risk questions use the same simulation and exposure logic. Liquidity questions meet it again in margin calls and funding costs. Current issues on private credit and geopolitical risk also touch counterparty exposure.

The FRM Part II exam has 80 equally weighted multiple-choice questions in 4 hours, and many are applied. This chapter suits that style because it mixes calculation with interpretation. You may be asked to compute a CVA from an exposure profile, explain why netting reduces exposure, or say whether a trade shows wrong-way risk. The concepts are linked, so a solid grasp earns marks across several questions and also helps in credit and liquidity topics. The arithmetic is usually short, so careful preparation turns into reliable marks.

Credit Value Adjustment: topics in the order to study them

  1. 1Credit Exposure and Exposure MetricsEvery later topic uses exposure, so learn the definitions first: current exposure, expected exposure, EPE, PFE and the effect of exposure profiles over time.
  2. 2Netting, Collateral and MarginingThese change the exposure number you carry into CVA, so you need them before pricing.
  3. 3Unilateral Credit Value Adjustment (CVA)This is the core formula, built on the exposure and mitigation you have already learned.
  4. 4Bilateral CVA and Debt Value Adjustment (DVA)It extends the unilateral model by adding your own default, so the base formula must be solid first.
  5. 5Wrong-Way and Right-Way RiskIt tests the independence assumption behind the earlier formulas, so it comes after you know them.
  6. 6CVA Hedging, Capital and Funding AdjustmentsIt is the practical wrap-up and needs all prior ideas: exposure, CVA, DVA and dependence.

How to prepare Credit Value Adjustment

Aim to understand the chain from exposure to price, then practise short calculations until they are automatic.

  1. Learn the exposure terms with a simple swap profile in mind. Be able to sketch how expected exposure rises and then falls as the swap matures.
  2. Study netting and collateral together. Note what each does and what it cannot remove, such as the gap between a default and the close-out of the position (the margin period of risk).
  3. Memorise the unilateral CVA formula in words and symbols: CVA ≈ LGD × Σ EE(ti) × PD(ti-1, ti), with discounting. Work three or four numerical examples by hand.
  4. Add DVA as the mirror image. Be clear on sign, who benefits, and why it is controversial for accounting and risk.
  5. Build a short list of wrong-way and right-way examples. For each, say how exposure and default probability move together.
  6. Finish with hedging, capital and funding adjustments. Know what a CDS hedge covers and what it leaves unhedged, such as the market risk of CVA itself.
  7. Do timed mixed practice. Read each question for the risk measure asked, then check the method and the interpretation.

Common mistakes in Credit Value Adjustment

  • Mixing up expected exposure and potential future exposure.

    Fix: Remember: EE is an average of positive exposure, PFE is a high percentile. CVA uses EE; limits often use PFE.

  • Forgetting to apply LGD, using the full exposure as the loss.

    Fix: Always write LGD = 1 − recovery rate first, and multiply it in before you add up the terms.

  • Assuming collateral removes all exposure.

    Fix: Check for thresholds, minimum transfer amounts and the margin period of risk. Exposure remains for the gap between the last margin call and close-out.

  • Getting the sign and meaning of DVA wrong.

    Fix: Treat DVA as the counterparty's CVA on you. It adds to value, and it grows as your spread widens.

  • Treating exposure and default as independent when the question hints otherwise.

    Fix: Look for links, such as a counterparty selling protection on its own sector. If exposure and default rise together, name wrong-way risk.

  • Treating a CDS hedge as a full hedge of CVA.

    Fix: State that the hedge leaves exposure risk, basis risk and jump-to-default gaps. Questions on hedging often turn on this.

Last-day revision: Credit Value Adjustment

  • Current exposure is the greater of the current replacement value and zero.
  • Expected exposure is the average positive exposure at a future date; PFE is a high percentile of exposure at that date.
  • Netting applies only under an enforceable netting agreement and lowers exposure to the net positive amount.
  • Collateral lowers exposure but leaves a residual risk over the margin period of risk.
  • Unilateral CVA ≈ LGD × Σ discounted EE × marginal default probability, where LGD = 1 − recovery rate.
  • Unilateral CVA is a cost to you; it reduces the value of the portfolio.
  • Bilateral CVA = CVA − DVA, where DVA is the gain from your own default risk.
  • DVA rises when your own credit spread widens, which is why it is criticised.
  • Wrong-way risk means exposure rises as the counterparty's credit quality falls; right-way risk is the reverse.
  • Wrong-way risk makes CVA larger than an independence-based calculation would show.
  • A CDS hedge covers credit spread risk in CVA but not the exposure (market) risk.
  • Funding adjustments reflect the cost of funding uncollateralised positions and are separate from CVA.

Credit Value Adjustment practice questions

Credit Value Adjustment in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Value Adjustment: frequently asked questions

What is the CVA formula I need for FRM Part II?

In its basic form, CVA ≈ LGD × Σ EE(ti) × PD between dates, with discounting. Here LGD is 1 minus the recovery rate and EE is the expected exposure. Practise it with a short table of exposures and default probabilities.

Is DVA included in regulatory capital for CVA?

Regulatory capital for CVA risk is aimed at losses from counterparty credit spread moves, and it does not give credit for your own DVA. Treat DVA mainly as an accounting and pricing concept. Check your reading for the exact treatment GARP presents.

How is wrong-way risk tested?

Usually through a short scenario where a counterparty's default is linked to the value of the trade, and you must identify the risk and its effect on CVA. You may also compare it with right-way risk. Focus on the direction of the link.

How much calculation should I expect in this chapter?

Expect short, manageable calculations, such as a CVA from a few exposure points or the effect of netting. The remaining questions test interpretation of the concepts. Practise both types in timed sets.