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

Under the Basel III CVA capital framework, a bank hedges the CVA risk of a counterparty using a single-name CDS on that counterparty. A risk manager notes that hedging with the CDS on the exact counterparty reduces CVA capital, whereas hedging with an index CDS provides less relief. What is the main reason?

A single-name CDS on the same counterparty is a direct hedge and gets full capital recognition, while an index CDS leaves basis risk between the index and the name, so it gets only partial recognition. Index hedges are still recognized, and neither hedge removes exposure risk.

  1. AIndex hedges are not recognized at all under any approach
  2. BSingle-name CDS on the same entity is a direct hedge, while an index hedge leaves basis risk and receives a lower hedge recognitionCorrect
  3. CIndex CDS positions are risk weighted at a higher rate than the counterparty exposure
  4. DSingle-name hedges eliminate exposure risk as well as spread risk

Explanation

Basel's CVA framework recognizes eligible hedges, with direct single-name hedges giving full offset and index hedges giving only partial recognition because of basis between the index and the specific name. Index hedges are recognized, so option 1 is wrong. Single-name CDS do not remove exposure risk, so option 4 is wrong.

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