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

A bank's independent CVA on a netting set is computed as the sum over three annual periods of (discounted expected exposure x marginal default probability x LGD). Discounted EE under independence is 10, 8 and 6 (USD million) for years 1-3, marginal default probabilities are 2%, 3% and 4%, and LGD is 60%. The wrong-way risk model shows that conditional on default in each period, the discounted exposure is 1.5 times the unconditional figure. What is the wrong-way-adjusted CVA in USD million?

The wrong-way-adjusted CVA is USD 0.6120 million. Independent CVA is 0.6 times 0.68, or 0.408 million, and because exposure conditional on default is 1.5 times higher, the CVA scales by 1.5 to 0.612 million.

  1. A0.6120
  2. B0.4080
  3. C0.9180Correct
  4. D0.7344

Explanation

Independent CVA = 0.6 x (10x0.02 + 8x0.03 + 6x0.04) = 0.6 x (0.20+0.24+0.24) = 0.6 x 0.68 = 0.408. With conditional exposure 1.5 times higher, CVA = 0.408 x 1.5 = 0.612. Wait: 0.408 x 1.5 = 0.612, which is option 1; 0.918 would wrongly apply 2.25 (1.5 squared).

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