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

A bank has a receive-fixed interest rate swap with a corporate counterparty whose credit quality improves when rates fall... Specifically, the counterparty's credit quality tends to improve when the swap's value to the bank rises. How should this be described for CVA purposes?

This is right-way risk. Exposure is highest when the counterparty is financially stronger and less likely to default, so expected exposure given default is lower than the unconditional figure, and CVA is lower than an independence-based calculation would show.

  1. ARight-way risk, which can reduce CVA relative to an independence assumptionCorrect
  2. BWrong-way risk, which must increase CVA
  3. CSpecific wrong-way risk requiring zero recovery
  4. DBasis risk unrelated to CVA

Explanation

When exposure is high the counterparty is less likely to default, so exposure conditional on default is lower than unconditional exposure. This is right-way risk, and CVA would be lower than under independence. Wrong-way risk is the opposite dependence.

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