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

A bank has an uncollateralised derivative whose exposure to a counterparty tends to rise when the counterparty's credit quality falls, such as a put option on the counterparty's own shares. How does this wrong-way risk affect CVA calculated with exposure and default probability assumed independent?

The independent CVA is understated. Under wrong-way risk, exposure rises as the counterparty's credit quality deteriorates, so large exposures coincide with high default probability. Assuming independence ignores this positive dependence and gives a lower CVA than is appropriate.

  1. ACVA is understated, because exposure is correlated positively with default probabilityCorrect
  2. BCVA is overstated, because default probability falls when exposure is high
  3. CCVA is unaffected, because independence is conservative
  4. DCVA becomes equal to DVA

Explanation

Under wrong-way risk, exposure is high precisely when default is likely, so the product of exposure and default probability is larger than the independent calculation implies. Therefore the independent CVA understates the true charge.

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