Credit Risk Management Practice Exam

What effect does collateralization have on CVA?

1. It increases the CVA due to higher exposure

2. It has no measurable effect

3. It reduces the CVA by changing expected exposure

4. It makes calculations more complex without benefits

The correct answer is: It reduces the CVA by changing expected exposure

Collateralization plays a critical role in credit risk management, particularly concerning Credit Valuation Adjustment (CVA). When collateral is posted in a financial transaction, it serves as a security that mitigates the credit risk between counterparties. This mechanism directly influences the expected exposure in these transactions. The essence of CVA is to quantify the potential loss from counterparty default. By collateralizing a transaction, the potential loss is reduced because the collateral can be liquidated to cover losses incurred. This effectively lowers the expected exposure over the life of the transaction. As a result, the overall risk associated with the counterparty is diminished, leading to a reduced CVA. Additionally, collateralization may improve the credit quality of the transaction and lower the likelihood of default by decreasing the net exposure that one party faces in case of a counterparty’s financial difficulties. Therefore, collateralization is an effective strategy for enhancing the credit profile of derivatives transactions and reducing the corresponding CVA. In contrast to this correct answer, other choices do not accurately reflect the dynamics between collateralization and CVA. For instance, suggesting that collateral has no measurable effect fails to recognize the significant reduction in credit risk that collateral brings. Moreover, implying that it increases CVA due to higher exposure is misleading