Credit Risk Management Practice Exam

What factors must be considered when evaluating the impact of default probability and recovery on CVA?

1. Credit spread levels and the shape of the credit spread curve

2. Recovery rate assumptions and market volatility

3. Regulatory changes and market trends

4. The underlying asset's fundamental value

The correct answer is: Credit spread levels and the shape of the credit spread curve

When evaluating the impact of default probability and recovery on Credit Valuation Adjustment (CVA), it is essential to consider credit spread levels and the shape of the credit spread curve. Credit spreads reflect the difference in yield between a risk-free asset and a credit risk-bearing asset, indicating the market's perception of the credit risk associated with that asset. A wider credit spread typically suggests a higher probability of default, which directly influences the risk assessment in CVA calculations. Furthermore, the shape of the credit spread curve provides insights into the market's expectations for credit risk over different maturities. An upward sloping curve might indicate increasing risk over time, while a downward slope could suggest market confidence in overcoming potential defaults in the early stages. Focusing on these elements is paramount for accurately assessing how changes in default probability and recovery rates could impact the overall credit risk exposure represented in CVA. While other choices may include relevant aspects, they do not specifically address the core relationship between credit risk metrics and their direct effects on CVA values.