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

A bank simulates exposure on a 5-year cross-currency swap using risk-neutral drift for the FX rate and interest rates calibrated to market-implied data, for use in CVA pricing. A regulator asks the bank to use the same engine to assess the potential future exposure for limit setting. What is the most appropriate concern?

The concern is that risk-neutral calibration, appropriate for pricing CVA, ignores real-world drift and risk premia and uses market-implied parameters. For limit setting and PFE, a historically calibrated real-world simulation is generally more appropriate, because the two measures can differ materially.

  1. ARisk-neutral calibration may misstate real-world exposure because drift and risk premia differ, so limit-setting typically calls for historical (real-world) calibrationCorrect
  2. BRisk-neutral simulation is unusable for any exposure measure because it ignores volatility
  3. CReal-world calibration should never be used for any exposure metric because it is not arbitrage-free
  4. DCalibration choice has no effect on exposure because both measures give the same expected path

Explanation

CVA pricing uses risk-neutral parameters implied by market prices, while PFE for risk limits and capital is a risk-management measure that should reflect real-world dynamics, including drift and historically estimated volatility and correlation. Results can differ materially, so using the pricing calibration for limits is a concern.

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