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

A bank has an expected positive exposure profile to a counterparty that was computed assuming independence between exposure and default. Which approach is most appropriate to capture wrong-way risk in CVA?

The appropriate approach is to model dependence between the counterparty's default intensity and the market factors that drive exposure, such as a correlated stochastic credit spread. Simply adjusting recovery, horizon or using current value does not capture the joint behaviour of exposure and default.

  1. AModel dependence between the counterparty's hazard rate and the exposure drivers, for example via correlated stochastic credit spread and market factorsCorrect
  2. BIncrease the recovery rate to offset the higher exposure
  3. CReplace the exposure profile with the current mark-to-market only
  4. DReduce the time horizon so fewer default dates are considered

Explanation

Wrong-way risk requires exposure and default probability to be dependent, so the model must link hazard rates to market risk factors, such as a stochastic credit spread correlated with exposure. Raising recovery lowers loss and ignores dependence. Using only current MtM ignores future exposure. Shortening the horizon removes risk rather than modelling it.

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