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

A bank hedges CVA spread risk with CDS but finds that the P&L still moves when market volatility rises sharply, even though credit spreads are unchanged. Which sensitivity is the likely cause?

The P&L moves because CVA depends on expected exposure, which increases with volatility on option-like trades. CDS hedges only credit spread sensitivity, so the exposure-driven market risk component, such as vega, remains unhedged unless the desk adds separate market risk hedges.

  1. AExposure sensitivity to market risk factors, such as vega of the underlying derivative exposure, which CDS does not hedgeCorrect
  2. BPure recovery rate risk from the CDS contract
  3. CSettlement risk on the CDS
  4. DThe bank's own capital ratio

Explanation

CVA depends on expected exposure, which rises with volatility for option-like positions. CDS hedges credit spread (CS01) only, leaving market-risk sensitivities such as vega, delta and rates unhedged unless separately hedged.

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