Credit Risk Management Practice Exam

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Which of the following can describe the CVA's nature when calculated?

It has no inherent cost
It can be interpreted as a risk-adjusted spread
It is fixed as a function of LGD only
It has no correlation with EPE

The correct answer is: It can be interpreted as a risk-adjusted spread

Credit Valuation Adjustment (CVA) is a critical measure in credit risk management that represents the risk of loss due to counterparty default. When calculating CVA, it captures the risk-adjusted nature of the expected exposure to counterparty credit risk. By interpreting CVA as a risk-adjusted spread, it reflects the extra yield that investors demand as compensation for taking on the credit risk of a counterparty. This makes it an essential tool for evaluating risk in financial transactions and derivatives, where the potential for counterparty default affects pricing and risk assessments. This interpretation helps market participants quantify the risk more accurately and incorporate it into their pricing models. In contrast, options that discuss aspects like inherent costs, a fixed relation to the Loss Given Default (LGD), or correlation with Expected Positive Exposure (EPE) do not capture the essence of CVA. The nature of CVA is inherently linked to the variability of counterparty risk rather than fixed aspects or unrelated metrics. Understanding CVA as a risk-adjusted spread emphasizes its role in managing credit risk in a dynamic market environment.