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

A bank has an uncollateralised swap with a counterparty whose default probability is positively correlated with the swap's exposure, for example a commodity producer selling forward its own output. Compared with the standard CVA that assumes independence, how should the bank expect the CVA to behave and why?

CVA is higher than the independence-based figure. This is wrong-way risk: the counterparty is more likely to default when the exposure is large, so exposure conditional on default exceeds the unconditional expected exposure and the standard calculation understates the loss.

  1. AIt is higher, because exposure tends to be large precisely when default is more likely (wrong-way risk)Correct
  2. BIt is lower, because exposure tends to fall when default is more likely
  3. CIt is unchanged, because CVA depends only on the spread
  4. DIt is zero, because correlation removes the expected loss

Explanation

With positive dependence between exposure and default, the exposure conditional on default exceeds the unconditional expected exposure. The independence-based CVA therefore understates the loss. Lower or unchanged CVA would only arise with right-way or no dependence.

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