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

A bank's CVA desk buys single-name credit default swap protection on a corporate counterparty to reduce the volatility of its CVA. Which residual risk remains even after the CDS notional is matched to the current expected exposure?

The key residual risk is that exposure varies with market moves, so a fixed CDS notional will not track it. The CVA desk must keep rebalancing and remains exposed to market-driven and wrong-way exposure changes, even though the CDS protects against default on a fixed amount.

  1. AExposure changes over time, so the hedge notional must be rebalanced and the bank has gamma-like wrong-way and market-driven exposure riskCorrect
  2. BThe CDS removes all exposure risk because it pays on default of the counterparty
  3. CThe hedge eliminates the counterparty's recovery rate uncertainty entirely
  4. DThe CDS spread becomes irrelevant to CVA once protection is bought

Explanation

Counterparty exposure is stochastic and depends on market factors, so a static CDS notional cannot match it at all times. The bank is left with exposure-driven risk requiring rebalancing. A CDS hedges credit spread and default loss on a fixed notional, not a changing exposure.

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