# P2.T6.901. Credit exposure and valuation adjustments (Gregory, Ch.4)

#### Nicole Seaman

##### Director of FRM Operations
Staff member
Subscriber
Learning objectives: Describe credit exposure, credit migration, recovery, mark-to-market, replacement cost, default probability, loss given default, and the recovery rate. Describe credit value adjustment (CVA) and compare the use of CVA and credit limits in evaluating and mitigating counterparty risk.

Questions:

901.1. Freecone Financial LLC entered into an interest rate swap some time ago where it agreed to make semi-annual fixed payments at a rate of 3.0% per annum, in exchange for receiving floating payments on a notional amount of $50.0 million. The floating rate is the six-month secured overnight financing rate (SOFR) and this is also the discount rate used to value the swap. The swap has a remaining life of 1.25 years. The SOFR rate applicable to the exchange in three months was determined three months ago: it was 2.40%. Just as with a LIBOR-based swap, the floating rate is observed at the beginning of each six-month period but paid at the end of the period. Currently, the SOFR term structure is flat at 2.60% per annum with continuous compounding. With respect to its position in this swap, which of the following is nearest to Freecone Financial's current exposure? a. Zero b. -$335,900
c. +$335,900 d. +1,335,900 901.2. Casper Ghost Limited (aka, Casper) is a market maker with a position in an over-the-counter (OTC) fixed-for-floating "vanilla" interest rate swap that has a notional value of$80.0 million.
• Mark-to-market is not immediately available
• Replacement cost is 3.0% of notional, or $2.4 million • The potential future exposure (PFE) is estimated to be 4.5% of notional, or$3.6 million
• The estimate for counterparty default (PD) is 1.0%
• The estimate for loss given default (LGD) is 50.0%
Which of the following is the best approximation of exposure at default, EAD?

a. Exposure at default (EAD) is the mark-to-market, so it needs to be calculated
b. EAD is approximated by the replacement cost, in this case, $2.4 million c. EAD is approximated by replacement cost plus PFE, in this case,$6.0 million
d. EAD is approximated by ($80.0 million +$3.6 million) * 3.0% * 1.0% * 50%

901.3. Herman, Ferry and Quitzon LLC is a market maker with a position in an over-the-counter (OTC) derivatives contract. For this position, they have estimated the following values:
• The riskfree (aka, riskless) value of their position is +$32.0 million • The credit valuation adjustment (CVA) is$5.0 million
• The debt valuation adjustment (DVA) is $8.0 million Based only on this information, which of the following is the best estimate of the RISKY VALUE of the position from Herman's perspective? a. Risky value =$27.0 million
b. Risky value = $29.0 million c. Risky value =$35.0 million
d. Without estimates for the counterparty's default probability (PD) and loss given default (LGD), we cannot estimate a risky value