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

A bank wants to incorporate wrong-way risk into its CVA calculation using a simple, commonly used approach that avoids full joint modelling of exposure and credit spreads. Which approach is the most appropriate?

The most appropriate simple approach is applying an alpha multiplier to the expected exposure in the independent-case CVA. This scales up exposure to reflect adverse dependence between exposure and default, without needing a full joint model of the two.

  1. AApply a multiplier (alpha) to the expected positive exposure used in the independent-case CVA calculationCorrect
  2. BReplace the counterparty's recovery rate with zero for all trades
  3. CCompute CVA using only the exposure at the first reporting date
  4. DUse the bank's own credit spread instead of the counterparty's spread

Explanation

A simple method scales the independent exposure profile by an alpha multiplier above one to reflect adverse dependence (the Basel internal model approach floors the multiplier at 1.2). Setting recovery to zero or using only one date does not capture dependence, and using the bank's own spread would measure DVA-type effects, not wrong-way risk.

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