FRM Exam Part II · Fundamental Review of the Trading Book

FRTB Default Risk Charge, Securitization and CVA Capital

Updated 11 October 2026 · Fact-checked

Under FRTB, the default risk charge (DRC) captures jump-to-default losses on trading book credit and equity positions. Securitizations must use the standardized approach. CVA risk is capitalised separately, through BA-CVA or SA-CVA. To solve questions: identify the position type, compute net jump-to-default amounts, apply risk weights, then apply the hedge benefit or aggregation formula.

Understand Credit Valuation Adjustment and Securitization Treatment

Sensitivity-based capital in FRTB captures losses from spread and price moves. It does not capture a sudden default, where a bond loses most of its value in one step. The default risk charge (DRC) fills this gap. It measures jump-to-default (JTD) risk on trading book positions, such as bonds, CDS and equities.

The standardized DRC has three separate pieces: non-securitizations, securitizations outside the correlation trading portfolio, and the correlation trading portfolio (CTP). Each piece is computed on its own, and you do not offset across them. For non-securitizations, you compute a JTD amount for each position, net long and short positions to the same obligor, and apply default risk weights by credit quality. Then you apply a hedge benefit ratio inside each bucket (corporates, sovereigns, local governments). Bucket charges are added with no diversification between buckets.

Securitizations are treated more harshly. Securitization positions are not eligible for the internal models approach (IMA), so they go to the standardized approach. Offsetting is very limited, and risk weights follow the securitization framework. Only the CTP, a limited book of correlation trading positions and their hedges, gets more offsetting.

Under the IMA, the DRC is a modelled charge. It replaces the Basel 2.5 incremental risk charge (IRC). Both use a 99.9% confidence level over one year. The key difference: the IRC covered default and rating migration and used liquidity horizons. The DRC covers default only, uses a one-year horizon, and applies to equity as well as credit positions. Securitizations are excluded from the IMA DRC.

CVA risk is a different risk. It is the risk of mark-to-market losses on derivative and securities financing transaction values caused by changes in counterparty credit spreads (and exposure drivers). It is not the risk of the counterparty actually defaulting, which sits in counterparty credit risk capital. The framework offers two approaches: the basic approach (BA-CVA) and the standardized approach (SA-CVA), which needs supervisory approval. Transactions with qualifying central counterparties are out of scope. Eligible CVA hedges are removed from the market risk charge so they are not counted twice.

Key formulas to remember

Gross JTD for a long position: JTD(long) = max(LGD × Notional + P&L, 0); P&L = market value − notional. Prescribed LGD: 100% for equity and non-senior debt, 75% for senior debt, 25% for covered bonds.
Gross JTD for a short position: JTD(short) = min(−LGD × |Notional| + P&L, 0); Shorts give negative JTD (a gain on default). Net long and short JTD to the same obligor before applying risk weights.
DRC risk weights (non-securitization): AAA 0.5%; AA 2%; A 3%; BBB 6%; BB 15%; B 30%; CCC 50%; unrated 15%; defaulted 100%; Weights are default probabilities by credit quality. Memorise the order and the unrated figure.
Hedge benefit ratio: WtS = ΣNet JTD(long) ÷ (ΣNet JTD(long) + Σ|Net JTD(short)|); Computed within each bucket. A higher ratio means shorts get less credit.
Bucket DRC: DRC(bucket) = max[ Σ RW × Net JTD(long) − WtS × Σ RW × |Net JTD(short)| ; 0 ]; Total DRC is the sum of bucket charges. There is no diversification across buckets.
BA-CVA counterparty term: SCVA(c) = (1 ÷ α) × RW(c) × Σ [M × EAD × DF] over netting sets, with α = 1.4; DF = 1 for banks using SA-CCR for exposure. For IMM banks DF = (1 − e^(−0.05M)) ÷ (0.05M). RW depends on sector and investment-grade or high-yield status.
Reduced BA-CVA: K(reduced) = √[ (ρ × ΣSCVA(c))² + (1 − ρ²) × ΣSCVA(c)² ], ρ = 50%; Sums are over counterparties. No hedge recognition in the reduced version. The full version adds hedge recognition for eligible hedges.
SA-CVA structure: Capital = m(CVA) × (K delta + K vega); Sensitivity-based, built on counterparty credit spread and exposure risk factors. It needs supervisory approval. The multiplier m(CVA) is set by the supervisor, default 1.

How to solve Credit Valuation Adjustment and Securitization Treatment questions

Use this order for any question on default risk, securitization or CVA capital under FRTB.

1Identify the risk being asked about: default (JTD) risk, securitization capital, or CVA risk. Do not mix CVA with counterparty default capital.
2Identify the approach: standardized or internal models. Securitizations always go to the standardized approach.
3For a DRC question, compute gross JTD for each position using LGD and P&L. Then net long and short positions to the same obligor.
4Assign each obligor to a bucket (corporate, sovereign, local government) and apply the risk weight for its credit quality.
5Compute the hedge benefit ratio WtS, then apply it to the weighted short exposures inside the bucket. Floor each bucket at zero and sum buckets.
6For a CVA question, check scope (exclude qualifying CCP trades), compute SCVA for each counterparty, then aggregate with ρ = 50% for BA-CVA.
7For comparison questions (IRC vs DRC, BA vs SA), state the differences in risk coverage, horizon, confidence level and eligibility.
8Check units and sign: shorts are negative JTD, capital cannot be negative at bucket level, and write the answer in the currency of the question.

Quickest way: Four-line DRC and CVA shortcut

When to use it: Use it when a numerical question gives net JTD amounts or EADs and you have about two minutes.

DRC: write long weighted total, then WtS, then weighted shorts times WtS. Subtract. Do not round WtS early.
DRC conceptual: remember default only, 99.9%, one year, includes equities, no migration. That separates DRC from IRC.
BA-CVA: compute each SCVA first. Then test ρ: the answer lies between √(ΣSCVA²) (ρ = 0) and ΣSCVA (ρ = 1). Use this to reject wrong options.
Securitization: if the question mentions IMA for securitizations, it is wrong. If it mentions full netting across tranches, it is almost certainly wrong.

Common mistakes in Credit Valuation Adjustment and Securitization Treatment

Saying the DRC includes rating migration like the IRC.
Students remember that DRC replaced IRC and assume it carries over all the features.
Fix: DRC is default only. The IRC included migration and used liquidity horizons. The DRC uses a one-year horizon and applies to equity as well.
Allowing securitizations into the internal models DRC.
The IMA is seen as the general route for any trading book credit exposure.
Fix: Securitizations, including the CTP, are capitalised under the standardized approach. Remember this as a hard rule.
Offsetting across buckets or giving full credit to shorts.
Students treat the DRC like a simple net exposure sum.
Fix: Offsetting is allowed only within the same obligor, and then shorts are scaled by WtS inside a bucket. Bucket charges add up, and each is floored at zero.
Treating CVA capital as protection against counterparty default.
The word credit in CVA suggests default loss.
Fix: CVA capital covers mark-to-market losses from spread changes. Default of the counterparty is covered by counterparty credit risk capital.
Dropping the 1 ÷ α factor or using ρ wrongly in BA-CVA.
The square-root formula looks like a variance formula and details get lost.
Fix: Compute SCVA with 1 ÷ 1.4 first. Then use ρ = 50% on the sum of SCVA terms and (1 − ρ²) on the sum of squares.
Including trades with qualifying central counterparties in CVA capital.
All derivatives look in scope.
Fix: Exclude trades with QCCPs. Include OTC derivatives and fair-valued securities financing transactions with other counterparties.

Worked examples

Example 1

A bank holds corporate positions in one DRC bucket. Net JTD long: obligor A (BBB) USD 7.1 million; obligor C (BB) USD 3.0 million. Net JTD short: obligor B (A-rated) USD 4.0 million, shown as a positive amount. Compute the bucket DRC.

Show the solution

Risk weights: BBB 6%, BB 15%, A 3%.
Weighted long: 0.06 × 7.1 = 0.426; 0.15 × 3.0 = 0.450. Total = USD 0.876 million.
Weighted short: 0.03 × 4.0 = USD 0.120 million.
Hedge benefit ratio: WtS = (7.1 + 3.0) ÷ (7.1 + 3.0 + 4.0) = 10.1 ÷ 14.1 = 0.7163.
Scaled short credit: 0.7163 × 0.120 = 0.0860.
Bucket DRC = max(0.876 − 0.0860, 0) = 0.790.

Answer: The bucket DRC is about USD 0.790 million.

Example 2

A bank using SA-CCR (DF = 1) applies the reduced BA-CVA with α = 1.4 and ρ = 50%. Counterparty 1: RW 5%, one netting set with EAD USD 20 million and M = 2 years. Counterparty 2: RW 3%, one netting set with EAD USD 50 million and M = 4 years. Compute K(reduced).

Show the solution

SCVA(1) = (1 ÷ 1.4) × 0.05 × (2 × 20 × 1) = 2 ÷ 1.4 = 1.4286.
SCVA(2) = (1 ÷ 1.4) × 0.03 × (4 × 50 × 1) = 6 ÷ 1.4 = 4.2857.
Sum of SCVA = 5.7143. ρ × sum = 2.8571; squared = 8.1633.
Sum of squares = 1.4286² + 4.2857² = 2.0408 + 18.3673 = 20.4082. Multiply by (1 − 0.25) = 0.75 to get 15.3061.
Total under root = 8.1633 + 15.3061 = 23.4694. Square root = 4.844.
Sanity check: 4.844 lies between √20.4082 = 4.517 and 5.714.

Answer: K(reduced) is about USD 4.84 million.

Exam tips

Expect a conceptual MCQ on IRC versus DRC. Learn the four differences: migration, liquidity horizons, equity coverage and securitization treatment.
For numerical DRC questions, the examiner usually gives net JTD amounts and ratings. Memorise the risk weight ladder so you can start at once.
In CVA questions, check whether the trade is with a qualifying CCP and whether the bank uses SA-CCR or IMM. These decide scope and DF.
If an option says CVA capital covers actual counterparty default, or that securitizations can use internal models, reject it.
Always state which charge you are computing and in which currency. Wrong-sign mistakes on short JTD cost easy marks.

Practice questions from Fundamental Review of the Trading Book

Credit Valuation Adjustment and Securitization Treatment in other exams

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

FRM Part ISecuritization and Structured Credit

Credit Valuation Adjustment and Securitization Treatment: frequently asked questions

What is the difference between IRC and the FRTB default risk charge?

The IRC under Basel 2.5 captured default and rating migration, and used liquidity horizons. The FRTB DRC captures default only over a one-year horizon at 99.9%. It also covers equity positions, and securitizations are excluded from the internal models DRC.

How are securitizations treated under FRTB?

Securitizations are not eligible for the internal models approach, so they are capitalised under the standardized approach. Offsetting is very limited, and the CTP gets slightly more recognition. Risk weights follow the securitization framework.

What are the two approaches for CVA capital in the revised framework?

The basic approach (BA-CVA) uses a formula based on exposure, maturity, sector risk weights and a correlation of 50%. The standardized approach (SA-CVA) is sensitivity-based and needs supervisory approval. Both cover CVA mark-to-market risk, not the counterparty default loss itself.

Does the DRC get diversification across buckets?

No. Within each bucket, shorts are recognised through the hedge benefit ratio and the bucket charge is floored at zero. The total DRC is the simple sum of the bucket charges.