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FRM Part II · FRM Exam Part II · Counterparty Risk and Beyond

A bank enters an uncollateralised swap with a client and simultaneously hedges it with a perfectly offsetting swap with a dealer under a full CSA with daily cash margining. When the client swap is in the bank's favour, the bank must post cash to the dealer, funded at a spread of 80 bps above the rate earned on posted collateral. Which statement best describes the resulting adjustment?

A funding cost adjustment arises and lowers the client trade's value. The bank must post cash on the collateralised hedge when the trade is in its favour but receives no collateral from the client, so it funds the gap at a spread. Offsetting market values do not remove this asymmetry.

  1. AA funding cost adjustment arises, reducing the value of the client trade because the bank must fund collateral posted on the hedge with no matching collateral receivedCorrect
  2. BA credit valuation adjustment arises only, because funding spreads are irrelevant when the hedge is collateralised
  3. CA debit valuation adjustment arises, increasing the trade value because the bank's funding spread reflects its own credit risk
  4. DNo adjustment arises because the two swaps offset exactly in market value

Explanation

The hedge requires posting collateral when the client trade has positive value, yet the client posts none, so the bank funds the gap at a spread. This cost is captured by a funding adjustment (FCA/FVA) that reduces value. Offsetting market values do not remove the funding asymmetry, and CVA addresses default loss, not funding.

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