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FRM Part II · FRM Exam Part II · Future Value and Exposure

A bank has a portfolio of CDS protection bought from a single dealer whose credit quality is strongly tied to the same sector as the reference entities. In modelling credit valuation adjustment with wrong-way risk, which approach would most directly capture the dependence between exposure and counterparty default?

Link the counterparty's hazard rate stochastically to the market risk factors driving exposure, or compute exposure conditional on default. This reflects the dependence between exposure and default, whereas unconditional exposure with a constant default probability assumes independence and understates wrong-way risk.

  1. AIncrease the counterparty's recovery rate to offset higher exposure
  2. BCompute exposure at the unconditional mean and apply a constant default probability
  3. CLink the counterparty's hazard rate stochastically to the risk factors driving exposure, for example via correlated processes or conditional exposure at defaultCorrect
  4. DReplace the expected exposure profile with the current mark-to-market only

Explanation

Capturing wrong-way risk requires a model where default intensity and exposure drivers are dependent, such as correlated hazard rate and market factor processes or exposure conditioned on default. Options 2 and 4 impose independence by construction. Raising recovery has no link to dependence and would reduce loss, understating risk.

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