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

A bank wants to hedge the credit spread component of its unilateral CVA on a corporate counterparty. Which instrument is most directly suited to this purpose?

The bank should buy protection through a single-name CDS on the counterparty. CVA rises when the counterparty's spread widens, and the purchased CDS gains value then, offsetting the loss. Selling protection would add to the exposure, and rate swaps or own-equity options do not address counterparty credit spreads.

  1. AA single-name credit default swap on the counterparty, bought as protectionCorrect
  2. BAn interest rate swap paying fixed in the same currency
  3. CAn equity put option on the bank's own shares
  4. DA sold credit default swap on the counterparty

Explanation

CVA increases when the counterparty's credit spread widens, so the bank buys protection through a single-name CDS, which gains in value in that case. Selling protection increases the exposure to the same risk. Rate swaps and own-equity puts do not target the counterparty spread.

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