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

A bank has a large portfolio of uncollateralised OTC derivatives with a corporate counterparty and wants to reduce the volatility of its accounting CVA charge caused by movements in the counterparty's credit spread. Which hedge is most directly suited to this purpose?

Buying single-name CDS protection on the counterparty is the most direct hedge, because CVA moves with the counterparty's credit spread and the CDS gains value when the spread widens, offsetting the increase in the CVA charge.

  1. ABuying single-name CDS protection on the counterpartyCorrect
  2. BEntering an offsetting interest rate swap with a different dealer
  3. CIncreasing the initial margin posted to the counterparty
  4. DSelling an equity index future

Explanation

CVA changes with the counterparty's credit spread, so a single-name CDS on that counterparty offsets the credit-spread component of CVA. An offsetting swap hedges market risk of the trade, not the credit spread. Posting more margin does not hedge CVA P&L, and an equity index future is unrelated.

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