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FRM Part II · FRM Exam Part II · Derivatives

A bank's risk team reviews the capital charge it holds against the possibility that its OTC derivative counterparties deteriorate in credit quality without defaulting, causing mark-to-market losses on the credit valuation adjustment. Which description best matches the purpose of the Basel CVA capital charge?

The Basel CVA capital charge covers mark-to-market losses from changes in the credit valuation adjustment, mainly driven by widening counterparty credit spreads, even when no default occurs. It was added after the crisis because most counterparty-related losses came from CVA volatility rather than from actual defaults.

  1. AIt covers losses from counterparty defaults that have already occurred during the margin period of risk
  2. BIt covers mark-to-market losses on expected counterparty credit risk arising from changes in counterparty credit spreadsCorrect
  3. CIt covers losses arising from failure of a central counterparty's default fund contribution
  4. DIt covers settlement risk on foreign exchange trades that fail to settle on the value date

Explanation

Under Basel III, the CVA capital charge was introduced because roughly two-thirds of counterparty losses in the crisis came from CVA mark-to-market movements rather than actual defaults. It therefore captures volatility of the CVA from credit spread changes (and exposure changes). The default charge is separate and covers actual default losses.

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