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P2.T6.713. Exposure profiles and credit value adjustment (CCR CVA)

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713.1. In counterparty credit risk (CCR), exposure profiles plot credit exposure against time. The metric is typically expected exposure (EE) or potential future exposure (PFE). Consider the following four exposure profiles for (a) a vanilla fixed-for-floating interest rate swap, (b) a 5-year loan, (c) a short European option position and (d) and long credit default swap; i.e., buying protection which is synthetically short the reference:



Each of the (above) four profiles is a plausible credit exposure curve except which is FALSE?

a. Fixed-for-floating interest rate swap
b. 5-year loan
c. Short European ATM option
d. Long credit default swap (CDS)


713.2. Each of the following statements about credit exposure metrics is true EXCEPT which is false?

a. If both the initial (t = 0) expected exposure is zero and the final (t = maturity) expected exposure is zero, then the expected positive exposure (EPE) must also be zero
b. Changing the confidence level (e.g., from 95.0% to 99.0%) DOES impacts potential future exposure (PFE) and maximum PFE but impacts NEITHER expected exposure (EE) NOR expected positive exposure (EPE)
c. Potential future exposure (PFE) should be retrieved from simulations of market variables based on REAL-WORLD, historically-informed measures rather than a risk-neutral, no-arbitrage framework informed by market data
d. Although expected exposure and (EE) and effective EE have a shape (i.e., forward exposure curve) that varies over future time horizons, expected positive exposure (EPE) and effective EPE (EEPE) average into single point estimates, and EEPE cannot be less than EPE


713.3. A chief risk officer (CRO) asked her risk department to evaluate the bank’s 3-year derivative exposure to a counterparty. The 1-year credit default swap (CDS) on the counterparty is currently trading at a spread of 100 bps. The table below presents trade and forecast data on the the expected exposure, collateral, CDS spread, and the recovery rate with respect to the position:



Additionally, the CRO has presented the risk team with the following set of assumptions to use in conducting the analysis:
  • The counterparty’s default probabilities follow a constant hazard rate process
  • The investment bank and the counterparty have signed a credit support annex (CSA) to cover this exposure, which requires collateral posting throughout the life of the contract; as illustrated above, projected posted collateral will be $10.0, $15.0 and 20.0 million, respectively, in Years 1, Year 2, and Year 3.
  • The current risk-free rate of interest is 3.0% per annum with continuous compounding and the term structure of interest rates is predicted to remain flat over the 3-year horizon
Given the information and the assumptions above, what is nearest the correct estimate for the credit valuation adjustment (CVA) for this positon? Note: this question is inspired by GARP's 2017 P2 Practice Exam Question #76.

a. USD 0.803 million
b. USD 1.302 million
c. USD 2.580 million
d. USD 3.944 million

Answers here:

 
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