Financial Risk Manager Part 2
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Considering a scenario where a 3-year interest rate swap, identical in structure and terms to the previous arrangement between HIP Bank and ADB Banking Corporation, is initiated today, and assuming that the LIBOR curve remains unchanged while both banks have experienced downgrades resulting in increased credit spreads, which of the following statements is most likely accurate?
Considering a scenario where a 3-year interest rate swap, identical in structure and terms to the previous arrangement between HIP Bank and ADB Banking Corporation, is initiated today, and assuming that the LIBOR curve remains unchanged while both banks have experienced downgrades resulting in increased credit spreads, which of the following statements is most likely accurate?
Explanation:
The correct answer is C. Since both banks' credit spreads have increased due to their downgrades, this reflects a higher perceived credit risk for both HIP and ADB. The credit value adjustment (CVA) is a measure used to adjust the value of a financial contract or position for the credit risk of a counterparty. As the credit risk increases, so does the CVA, because the likelihood of the counterparty defaulting on its obligations has risen, and thus the expected loss from potential default is higher.
In the context of the question, the increase in credit spreads for both banks means that the market perceives a higher risk of default for both HIP and ADB. Consequently, the CVA on both sides of the contract would be higher to account for this increased risk. The debt value adjustment (DVA), on the other hand, is a measure that reflects the benefit to a financial institution from its own credit risk. It is not relevant in this scenario because the question pertains to the impact of counterparty credit risk on the swap contract, not the credit risk of the institution itself.
Therefore, the statement that both banks' spreads have increased leading to higher CVA on both sides of the contract is the most accurate reflection of the situation described. This is why option C is the correct answer.