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

A bank enters a total return swap in which it receives the return on a portfolio of bonds issued by firms in a single emerging-market country, from a counterparty that is the largest bank in that country. Which risk best describes the main concern for CVA?

This is general wrong-way risk. The reference bonds and the counterparty bank both depend on the same country-level economic conditions, so macro shocks can move exposure and the counterparty's default probability together, without any direct link such as the counterparty issuing the reference assets.

  1. AGeneral wrong-way risk, because a country-wide downturn would raise exposure and the counterparty's default probability togetherCorrect
  2. BRight-way risk, because the bond portfolio loses value in a downturn
  3. CSpecific wrong-way risk, because the counterparty issued the reference bonds itself
  4. DBasis risk only, because the swap reference is unrelated to the counterparty's credit

Explanation

The reference portfolio and the counterparty are both exposed to the same country-level factor, so a macro shock lowers asset values and weakens the bank. The bank receives the total return and the exposure to the counterparty increases when the portfolio gains, not loses, so the dependency needs care. Still, the dependency is through systemic factors, not the counterparty's own issuance, so it is general wrong-way risk.

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