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

A bank has an uncollateralised OTC derivative with a corporate counterparty. The bank's risk team notes that the counterparty's default probability tends to rise at the same time as the bank's exposure to it increases. Which description best fits this situation, and what is its effect on CVA computed assuming independence?

This is wrong-way risk, because exposure rises when the counterparty is more likely to default. Computing CVA while assuming independence ignores that positive dependence, so it understates the expected loss and therefore the true CVA.

  1. AWrong-way risk; CVA computed under independence understates the true CVACorrect
  2. BWrong-way risk; CVA computed under independence overstates the true CVA
  3. CRight-way risk; CVA computed under independence understates the true CVA
  4. DRight-way risk; CVA computed under independence overstates the true CVA

Explanation

Wrong-way risk arises when exposure and counterparty default probability are positively dependent. Losses then are concentrated in states where exposure is high, so the independence assumption underestimates expected loss and CVA. Option 2 reverses the effect; the right-way options describe negative dependence.

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