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Explanation:
Credit Value Adjustment (CVA) represents the discount to the standard risk-free derivative value to account for expected counterparty credit losses.
In this scenario:
Since Bank of Panamba provides the swap to Bank of Baroda, Panamba faces greater credit risk because Baroda's credit quality has deteriorated significantly (higher credit spread). To compensate for the heightened counterparty credit risk of Bank of Baroda, Bank of Panamba will request an increase in the CVA charge it receives.
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Q.25 Bank of Baroda often enters into swap contracts with Bank of Panamba – a major provider of swaps. In the last few months, Bank of Panamba was downgraded from a rating of A to a rating of A-, while Bank of Baroda was downgraded from a rating of BB+ to a rating of BB. Following these changes, the credit spread for Bank of Panamba has increased from 38 bps to 128 bps, while the credit spread for Bank of Baroda has increased from 118 bps to 228 bps. Which of the following actions will most likely be taken by the counterparties with respect to their credit value adjustment?
A
Bank of Panamba requests an increase in the CVA charge it receives
B
Bank of Baroda requests a reduction in the CVA charge it pays
C
CVA is no longer as important a factor, and therefore the counterparties will most likely migrate to other risk mitigation measures
D
Status quo remains because although the credit qualities of both institutions have migrated, the overall change is not sufficient to warrant an amendment of the existing CVA arrangement