Learning Objectives: Assess the credit risks of derivatives. Define credit valuation adjustment (CVA) and debt valuation adjustment (DVA). Calculate the probability of default using credit spreads. Describe, compare, and contrast various credit risk mitigants and their role in credit analysis.
24.20.1. As a financial analyst at Investments Bank Plc, you are tasked with assessing the credit risks associated with derivatives in the portfolio. Your review includes a variety of derivative instruments, such as swaps, forwards, and options. Which of the following factors should be considered as key when evaluating the credit risk of these derivatives?
a. Market volatility and the pricing models used for valuation.
b. The creditworthiness of counterparties and potential future exposure.
c. The underlying asset’s performance and liquidity in the market.
d. All of the above.
24.20.2. As a Risk Analyst at Investments Bank Plc, you are evaluating the credit risks associated with a derivative contract linked to a specific counterparty. You have been given the following financial metrics to work with a 5-year credit spread for the counterparty is 200 basis points (bps), the prevailing risk-free rate is set at 5%, and the recovery rate in case of default is assumed to be 40%.
Your task involves calculating the Probability of Default (PD) using the specified financial metrics and then assessing its implications on both the Credit Valuation Adjustment (CVA) and the Debt Valuation Adjustment (DVA) for a derivative contract. After calculating the PD, determine how changes in CVA reflect the counterparty’s credit risk and how changes in DVA reflect your own firm's credit risk. Select the statement that correctly describes these impacts.
a. PD = 5.82%; the CVA will increase, reflecting the counterparty's higher credit risk, reducing the derivative's valuation, while the DVA adjusts for the firm's own risk, potentially increasing the value if its credit worsens.
b. PD = 5.82%; The CVA will decrease as the counterparty's credit risk is manageable, increasing the derivative's valuation, while DVA remains unaffected as it only considers market conditions.
c. PD = 5.82%; The CVA will decrease as the counterparty's credit risk is manageable, increasing the derivative's valuation, while DVA remains unaffected as it only considers market conditions.
d. PD = 5.82%; The CVA will decrease as the counterparty's credit risk is manageable, increasing the derivative's valuation, while DVA remains unaffected as it only considers market conditions.
24.20.3. As the lead financial risk manager at Traditional Bank Plc, you are evaluating credit risk mitigants for the bank's portfolio, which includes corporate loans, derivatives, and structured finance products. Your team is considering additional risk mitigation tools due to the complexity of exposures and recent market volatility.
You observe the following:
In the context of enhancing credit risk management for a regional bank's diverse portfolio, the following statement(s) correctly describe(s) the role and effectiveness of various credit risk mitigants, EXCEPT for?
a. Statements i and ii.
b. Only statement ii.
c. Statements ii and iii.
d. Only statement iii.
Answers here:
24.20.1. As a financial analyst at Investments Bank Plc, you are tasked with assessing the credit risks associated with derivatives in the portfolio. Your review includes a variety of derivative instruments, such as swaps, forwards, and options. Which of the following factors should be considered as key when evaluating the credit risk of these derivatives?
a. Market volatility and the pricing models used for valuation.
b. The creditworthiness of counterparties and potential future exposure.
c. The underlying asset’s performance and liquidity in the market.
d. All of the above.
24.20.2. As a Risk Analyst at Investments Bank Plc, you are evaluating the credit risks associated with a derivative contract linked to a specific counterparty. You have been given the following financial metrics to work with a 5-year credit spread for the counterparty is 200 basis points (bps), the prevailing risk-free rate is set at 5%, and the recovery rate in case of default is assumed to be 40%.
Your task involves calculating the Probability of Default (PD) using the specified financial metrics and then assessing its implications on both the Credit Valuation Adjustment (CVA) and the Debt Valuation Adjustment (DVA) for a derivative contract. After calculating the PD, determine how changes in CVA reflect the counterparty’s credit risk and how changes in DVA reflect your own firm's credit risk. Select the statement that correctly describes these impacts.
a. PD = 5.82%; the CVA will increase, reflecting the counterparty's higher credit risk, reducing the derivative's valuation, while the DVA adjusts for the firm's own risk, potentially increasing the value if its credit worsens.
b. PD = 5.82%; The CVA will decrease as the counterparty's credit risk is manageable, increasing the derivative's valuation, while DVA remains unaffected as it only considers market conditions.
c. PD = 5.82%; The CVA will decrease as the counterparty's credit risk is manageable, increasing the derivative's valuation, while DVA remains unaffected as it only considers market conditions.
d. PD = 5.82%; The CVA will decrease as the counterparty's credit risk is manageable, increasing the derivative's valuation, while DVA remains unaffected as it only considers market conditions.
24.20.3. As the lead financial risk manager at Traditional Bank Plc, you are evaluating credit risk mitigants for the bank's portfolio, which includes corporate loans, derivatives, and structured finance products. Your team is considering additional risk mitigation tools due to the complexity of exposures and recent market volatility.
You observe the following:
- The bank's exposure includes derivatives with embedded downgrade triggers, as was notably the case with AIG during the 2008 financial crisis.
- Current risk mitigation techniques include netting agreements, collateral arrangements, and the use of credit derivatives.
- The team is also exploring the application of different models for estimating default correlations and assessing the effectiveness of various mitigants under different economic scenarios.
i. Downgrade triggers, as used by AIG, ensure that the bank does not have to post additional collateral as long as its credit rating remains above a specified threshold, thus preventing sudden liquidity demands during market downturns.
ii. Netting agreements reduce the bank’s total exposure by consolidating multiple transactions with a counterparty into a single net exposure, decreasing the potential credit risk from +$40 million to $15 million in a typical scenario.
iii. Collateral agreements, regulated to ensure fair treatment during defaults, allow the non-defaulting party to retain any posted collateral, thereby directly reducing potential losses from counterparty defaults.
In the context of enhancing credit risk management for a regional bank's diverse portfolio, the following statement(s) correctly describe(s) the role and effectiveness of various credit risk mitigants, EXCEPT for?
a. Statements i and ii.
b. Only statement ii.
c. Statements ii and iii.
d. Only statement iii.
Answers here:
