Credit Risk Management Practice Exam

Which of the following statements best describes credit value adjustment (CVA)?

1. It minimizes counterparty risk

2. It represents the price of counterparty risk

3. It is unrelated to collateral management

4. It has a fixed value regardless of contract types

The correct answer is: It represents the price of counterparty risk

The statement that credit value adjustment (CVA) represents the price of counterparty risk accurately captures the essence of what CVA is. CVA is a risk management tool used to quantify the risk of loss arising from a counterparty's default in a financial transaction. It effectively reflects the potential future exposure that a firm faces with respect to its counterparty, indicating the cost linked to this credit risk. When calculating CVA, financial institutions consider the probability of default of their counterparties, the potential exposure at the time of default, and the recovery rate in the event of default. Thus, CVA translates these risks into an adjusted market price for the transactions, allowing firms to factor in this cost when pricing derivatives and managing their capital reserves. This makes it a vital aspect in assessing the value of financial contracts, as it aligns the pricing with the inherent counterparty risk involved.