Explanation:
The correct answer is C.
Quantum Financial Consulting should expect that an increase in credit spread will generally result in an increase in CVA, as a wider credit spread indicates a higher perceived credit risk of the counterparty and thus a higher potential for loss if the counterparty defaults. Credit spread is a critical driver in the determination of CVA since it reflects the cost of counterparty default risk embedded in market prices.
A is incorrect because an increase in credit spread typically leads to an increase in CVA, not a decrease. The recovery rate does affect CVA, but higher recovery rates typically lead to lower CVA, not offsetting increases in credit spreads.
B is incorrect because while the recovery rate is important in the determination of CVA, credit spread is also a significant factor. Changes in credit spread can have a material impact on CVA calculations.
D is incorrect because CVA is sensitive to fluctuations in both credit spread and recovery rate. CVA adjustments are necessary to reflect such market changes in the firm's risk profile.
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Q.5488 Quantum Financial Consulting is reassessing the risk factors that affect their Credit Value Adjustment (CVA) calculations across their derivative portfolio. They especially want to refine the sensitivity of their CVA to dynamic market conditions. How should Quantum approach the impact of varying credit spread and recovery rate assumptions on their CVA calculations?
A
Quantum should anticipate that CVA will likely decrease with increasing credit spread and increasing recovery rate, resulting from the offsetting effects.
B
Quantum should primarily focus on changes in recovery rate assumptions, as credit spread has minimal impact on CVA calculations according to sensitivity.
C
Quantum should expect that an increase in credit spread will generally lead to an increase in CVA, reflecting heightened credit risk and potential losses.
D
Quantum should adjust their models with the presumption that CVA does not change meaningfully with fluctuations in credit spread and recovery rate under normal market conditions.