FRM Part II · FRM Exam Part II · Counterparty Risk and Beyond
A bank wants to reduce the volatility of its P&L caused by changes in the counterparty credit spreads that drive CVA. Which action is most direct?
The bank should buy CDS protection on its counterparties, or on an index proxy, sized to the CVA sensitivity to credit spreads. CVA increases when spreads widen, so the protection gains in that case and offsets the loss in CVA.
- ABuy CDS protection on the counterparties, or on an index proxy, sized to the CVA spread sensitivityCorrect
- BIncrease the number of netting sets
- CLengthen maturities of swaps
- DSell CDS protection on the counterparties
Explanation
CVA rises when spreads widen, so the bank is effectively short credit. Buying CDS protection gains when spreads widen and offsets the CVA loss. Selling protection would increase the exposure. Maturity extension raises exposure, not hedges it.
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