Answer: AUD 0.214 million

The question pertains to estimating the Credit Valuation Adjustment (CVA) for a 3-year derivative exposure position with a counterparty. The risk department is given several pieces of information, including the expected exposure, CDS spreads, and recovery rates for each year of the contract. The assumptions provided include a credit support annex, a flat risk-free rate of interest at 3%, and stable collateral and exposure values. To calculate the CVA, one would typically follow these steps: 1. **Estimate the Probability of Default (PD):** Use the CDS spreads to estimate the probability of default. The CDS spread is the annual cost of insuring against the default of the counterparty. It can be converted into a probability using market data or a model. 2. **Calculate Expected Exposure:** The expected exposure is given as AUD 14 million for each year. 3. **Determine the Loss Given Default (LGD):** The recovery rate is provided, which is the percentage of the exposure that would be recovered in the event of a default. The LGD is the complement of the recovery rate. 4. **Adjust for Collateral:** The credit support annex requires collateral posting of AUD 11 million, which reduces the exposure and thus the CVA. 5. **Discount Factor:** Apply the risk-free rate to discount the expected loss to the present value. 6. **Calculate the CVA:** The CVA is the present value of the expected loss from counterparty default. Given the information, the correct answer is calculated as follows: - The LGD for each year can be calculated as 100% - Recovery Rate. - For Year 1, LGD = 100% - 80% = 20%. - For Year 2, LGD = 100% - 70% = 30%. - For Year 3, LGD = 100% - 60% = 40%. The CVA calculation would involve estimating the probability of default for each year using the CDS spreads, adjusting for the collateral, and then calculating the expected loss for each year. These expected losses would then be discounted back to the present value using the risk-free rate. The provided answer is AUD 0.214 million, which suggests that the risk department has performed these calculations and arrived at this figure as the present value of the expected loss from counterparty default, adjusted for the collateral and the risk-free rate. It's important to note that the actual calculation would be more complex and would require specific models and market data to estimate the probability of default accurately. The provided answer assumes that these calculations have been done correctly and that the risk department's assumptions and methodology are valid.

Author: LeetQuiz Editorial Team