FRM II-CVA

anbu.edu
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FRM II-CVA

Postby anbu.edu » Wed Nov 05, 2014 5:26 pm

Acme Bank (A) is the floating-rate payer in an interest rate swap. Big Credit Corporation (B) is the counterparty who is the fixed-rate payer. Acme pays LIBOR in exchange for a fixed rate of 4.0% per annum. The credit valuation adjustment (CVA) to the mid-market value of the swap is given, per Canabarro, by CVA = E(A)*s(A) - E(B)*s(B); where E(A) is the present-valued expected exposure faced by Big Credit Corporation with respect to Acme Bank and s(A) is the risk-neutral loss rate of Acme Bank = PD(A) * LGD(A). From Acme Bank's perspective, the "net value" of the swap = credit-risk-free mid-market value + CVA. Consider three scenarios:
I. If the LIBOR curve increases, from Acme Bank's perspective, this will decreases the credit-risk-free value of the swap but will have zero effect on CVA
II. If Acme's credit spread increases, from Acme's perspective the net value of the swap (including CVA) will decrease
III. If Acme increases the quality of its collateral against the swap (i.e., lower collateral haircuts), from Acme's perspective the net value of the swap will increase
Which of the above is true?
a) None are true
b) Only I. is true
c) II. and III. are true
d. All are true

Answer
A. None are true.
In regard to (I), this is false because a gain in the swap value increases the expected counterparty exposure from Big Credit Corporation's perspective, which increases E(A) and therefore increases the CVA adjustment; i.e., mitigates the drop in value
In regard to (II), this is false because, from Acme's perspective, the value of the swap will INCREASE: s(A) increases due to the increase in the probability of default (PD) which increases the CVA adjustment, as the swap becomes less valuable to Big Credit Corp who now assumes more counterparty risk
In regrd to (III), this is false because the collateral benefit decreases LGD(A) which decreases s(A) which decreases the CVA adjustment from Acme's perspective; i.e., the net value of the swap increases for the counterparty, Big Bank, due to better collateral.

My doubt is if LIBOR increases then floating payment increase which will reduce the exposure inturn CVA... AM i wrong?

edupristine
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FRM II-CVA

Postby edupristine » Thu Nov 06, 2014 11:41 am

Hello anbu.edu,

If the LIBOR increases, then you are correct in saying that the floating rate payment increases.

Now when the floating rate payment increases, then the EXPOSURE INCREASES AND NOT DECREASES.

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

FRM II-CVA

Postby edupristine » Thu Nov 06, 2014 11:41 am

Hello anbu.edu,

If the LIBOR increases, then you are correct in saying that the floating rate payment increases.

Now when the floating rate payment increases, then the EXPOSURE INCREASES AND NOT DECREASES.

You should always keep in mind that as the value to be exchanged increases, the exposure always increases. Bcoz if the counterparty defaults, then a larger amount is at a risk of a loss.

Now, because the exposure increases, the CVA increases correspondingly.
Last edited by edupristine on Thu Nov 06, 2014 11:43 am, edited 1 time in total.

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

FRM II-CVA

Postby edupristine » Thu Nov 06, 2014 11:41 am

Hello anbu.edu,

If the LIBOR increases, then you are correct in saying that the floating rate payment increases.

Now when the floating rate payment increases, then the EXPOSURE INCREASES AND NOT DECREASES.


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