Credit Risk Management Practice Exam

How is CVA related to CDS premium?

1. It is typically higher than CDS premium

2. It directly varies with credit rating movements

3. CVA and CDS premium are unrelated

4. CVA calculated as a spread can be represented against CDS Premium

The correct answer is: CVA calculated as a spread can be represented against CDS Premium

CVA, or Credit Valuation Adjustment, represents the risk of counterparty default in derivatives transactions and is often expressed as a spread. This spread reflects the market's assessment of credit risk associated with a specific counterparty. On the other hand, the CDS premium, or credit default swap premium, is the cost that one party pays to another for protection against the risk of default by a reference entity. The correct relationship is that CVA and CDS premium can be compared on a similar basis, thus allowing CVA calculated as a spread to be represented against CDS premium. This is particularly useful in understanding market perceptions of credit risk. If the CDS premium rises, indicating increased perceived risk of default, one would also expect the CVA to increase correspondingly, reflecting the higher credit risk associated with the counterparty. This relationship helps risk managers and financial analysts gauge the risk associated with a counterparty relative to the market's assessment of credit risk for specific entities in similar situations. The notion that CVA can be expressed in terms of spreads offers insights into pricing strategies and risk assessments in the context of credit derivatives. In contrast, CVA typically being higher than the CDS premium does not hold universally, as it depends on the specifics of the transactions and market conditions.