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

A bank has a large uncollateralised swap book with an energy producer whose default probability tends to rise when oil prices fall, and the bank's swaps gain value when oil prices fall. What is the effect on CVA relative to a calculation assuming independence?

The independence assumption understates CVA. Exposure rises when oil prices fall, which is also when the producer is more likely to default. This is wrong-way risk, and ignoring the positive dependence between exposure and default probability underestimates the expected loss.

  1. ACVA is understated by the independence assumption because of wrong-way riskCorrect
  2. BCVA is overstated by the independence assumption because of right-way risk
  3. CCVA is unaffected because expected exposure is calculated under the risk-neutral measure
  4. DCVA falls because the correlation reduces the loss given default

Explanation

Exposure to the bank rises exactly when the counterparty is more likely to default, which is wrong-way risk. Independence ignores this positive dependence between exposure and default, so CVA is understated. Right-way risk would be the opposite situation.

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