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FRM Part II · FRM Exam Part II · Credit Value Adjustment

A bank computes CVA for a counterparty and finds positive correlation between the counterparty's default probability and the portfolio exposure, for example a company selling put options on its own shares to the bank. Compared with a calculation that assumes independence, what is the likely effect and implication?

Assuming independence understates CVA when exposure rises as the counterparty weakens. This is wrong-way risk: exposure at default exceeds the average expected exposure used in the independent calculation, so the bank needs to model the dependence explicitly.

  1. ACVA is understated under independence; this is wrong-way riskCorrect
  2. BCVA is overstated under independence; this is right-way risk
  3. CCVA is unchanged because exposure and default are separable
  4. DCVA is understated under independence; this is basis risk

Explanation

When exposure rises as the counterparty's credit quality deteriorates, the exposure at default is greater than the unconditional expected exposure. Independence therefore understates CVA. This is wrong-way risk, not right-way or basis risk.

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