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FRM Part II · FRM Exam Part II · Derivatives

A bank buys five-year CDS protection from a dealer on a corporate reference entity. The dealer is a bank in the same country, and its own credit spread is strongly positively correlated with the reference entity's spread. In pricing the CVA on this trade, which statement is correct?

CVA is higher than under independence. With positive correlation, the CDS gains value to the buyer exactly when the dealer is more likely to default, creating wrong-way risk and larger expected exposure at the counterparty's default.

  1. AWrong-way risk raises the expected exposure at the dealer's default, so CVA is higher than under an independence assumptionCorrect
  2. BPositive correlation reduces exposure at dealer default, so CVA falls
  3. CCorrelation has no effect on CVA if collateral is posted at the same frequency
  4. DCVA is zero because the CDS is a bilateral hedge

Explanation

When the reference entity's credit worsens, the CDS value to the buyer rises just as the dealer is more likely to default, so exposure at default is high. This is wrong-way risk and increases CVA relative to independence. Option B reverses the effect. Collateral mitigates but does not make correlation irrelevant, ruling out C.

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