Credit Risk Management Practice Exam

What is critical to the valuation of a risky swap agreement?

1. The size of the investment

2. The correlation between the counterparty's firm value and the variable payment

3. The duration of the swap

4. The credit rating of the counterparties

The correct answer is: The correlation between the counterparty's firm value and the variable payment

The critical factor in the valuation of a risky swap agreement is the correlation between the counterparty's firm value and the variable payment. This correlation is essential because it directly affects the likelihood of the counterparty’s ability to meet their payment obligations under the swap. If there is a strong positive correlation, as the value of the counterparty's firm increases, their capacity to fulfill their payment obligations also increases. Conversely, if the correlation is weak or negative, there may be higher risk because a decline in the counterparty’s value could lead to a higher probability of default. In the context of credit risk management, understanding this correlation helps in assessing the overall risk exposure of the swap agreement. It informs the valuation by factoring in how changes in the surroundings of the counterparty could influence their financial stability and ability to honor the swap provisions, leading to a more accurate assessment of the risk associated with the swap. The other options, while they may be relevant in different contexts, do not provide the same critical insight into the valuation process for a risky swap agreement. The size of the investment, for instance, does not directly inform the risk of counterparty default connected to variability in payments. Similarly, the duration of the swap focuses on the time frame rather than the inherent