LOCAL COMPANY, A FREQUENT USER OF SWAPS, OFTEN ENTERS INTO TRANSACT...

9.

Local Company, a frequent user of swaps, often enters into transactions with Global Bank, a major provider of

swaps. Recently, Global Bank was downgraded from a rating of AA+ to a rating of A, while Local Company

was downgraded from a rating of A to a rating of A-. During this time, the credit spread for Global Bank has

increased from 20 bps to 150 bps, while the credit spread for Local Company has increased from 130 bps to

170 bps. Which of the following is the most likely action that the counterparties will request on their credit

value adjustment (CVA)?

a.

The credit qualities of the counterparties have migrated, but not significantly enough to justify amending

existing CVA arrangements.

b.

Global Bank requests an increase in the CVA charge it receives.

c.

Local Company requests a reduction in the CVA charge it pays.

d.

CVA is no longer a relevant factor, and the counterparties should migrate to using other mitigants of

counterparty risk.

Correct Answer: c

Rationale:

Because Local Bank has a lower credit rating than Global Bank, it would typically pay a CVA charge to

Global Bank which would be a function of the relative credit spread between the two banks. After the downgrades

of both Global Bank and Local Bank, the credit spread between the two banks narrowed from 110 bps initially to

only 20 bps after the downgrades. Therefore, with the spread much lower between the two banks, Local Bank

would be in a position to request a reduction in the CVA charge that it pays.

Section: Credit Risk Measurement and Management

Reference:

Jon Gregory, Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global

Financial Markets, Chapter 12, "Credit Value Adjustment.”

Learning Objective:

Explain the motivation for and the challenges of pricing counterparty risk.

2015 Financial Risk Manager (FRM®) Practice Exam