Module: | MODULE B: RISK MANAGEMENT
Q371: Consider the following statements regarding the Credit Valuation Adjustment (CVA) within a bank's risk framework:
1. CVA represents the market value of counterparty credit risk and serves to downwardly adjust the risk-free mark-to-market valuation of a derivative.
2. Under the Basel framework, the CVA capital charge applies exclusively to over-the-counter (OTC) derivative transactions and explicitly excludes standard cash loans.
3. An increase in the counterparty's probability of default directly decreases the CVA capital charge required by the bank.
2. Under the Basel framework, the CVA capital charge applies exclusively to over-the-counter (OTC) derivative transactions and explicitly excludes standard cash loans.
3. An increase in the counterparty's probability of default directly decreases the CVA capital charge required by the bank.
✅ Correct Answer: A
The correct answer is A. Statement 1 is correct: Credit Valuation Adjustment (CVA) is fundamentally the market price of counterparty credit risk.
It calculates the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of the counterparty's default, resulting in a downward adjustment of the mark-to-market value.
Statement 2 is correct: The Basel regulatory CVA capital charge is explicitly designed for counterparty credit risk arising from Over-The-Counter (OTC) derivatives and Securities Financing Transactions (SFTs). It does not apply to standard on-balance-sheet cash loans.
Statement 3 is incorrect: The relationship is strictly proportional.
If the probability of default (PD) or credit spread of the counterparty increases, the risk of loss increases.
Consequently, the CVA capital charge requirement mathematically INCREASES, not decreases, to provide a sufficient buffer against the elevated risk.
It calculates the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of the counterparty's default, resulting in a downward adjustment of the mark-to-market value.
Statement 2 is correct: The Basel regulatory CVA capital charge is explicitly designed for counterparty credit risk arising from Over-The-Counter (OTC) derivatives and Securities Financing Transactions (SFTs). It does not apply to standard on-balance-sheet cash loans.
Statement 3 is incorrect: The relationship is strictly proportional.
If the probability of default (PD) or credit spread of the counterparty increases, the risk of loss increases.
Consequently, the CVA capital charge requirement mathematically INCREASES, not decreases, to provide a sufficient buffer against the elevated risk.