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

Independence-based CVA uses discounted expected exposure of 4.0 million in the period, default probability 2.0% and loss given default 60%, giving CVA of 0.048 million. With wrong-way risk, the expected exposure conditional on default is estimated at 6.5 million for the same period. Ignoring discounting differences, what is the revised CVA, and by how much does the independent estimate understate it?

Revised CVA is 6.5 million × 2.0% × 60% = 0.078 million. The independent figure of 0.048 million therefore understates CVA by 0.030 million, because exposure conditional on default is higher than the unconditional expected exposure.

  1. A0.078 million; understated by 0.030 millionCorrect
  2. B0.078 million; understated by 0.048 million
  3. C0.130 million; understated by 0.082 million
  4. D0.052 million; understated by 0.004 million

Explanation

Revised CVA = 6.5 × 2.0% × 60% = 0.078 million. Check independent: 4.0 × 0.02 × 0.6 = 0.048. Difference = 0.030. The 0.130 option omits LGD (6.5×0.02); the 0.052 option uses 6.5×0.02×0.4 (recovery instead of LGD).

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