Explanation:
Credit Value Adjustment (CVA) is the price of counterparty credit risk, effectively the discount to the standard risk-free value of a derivative to account for the expected loss due to the counterparty's default. Since Bank of Baroda's credit spread has widened significantly (from 118 bps to 228 bps, a deterioration of 110 bps), its probability of default has increased. To compensate for this heightened counterparty risk, Bank of Panamba (the dealer) will logically request an increase in the CVA charge it receives from Bank of Baroda. Although Bank of Panamba's own credit quality also deteriorated (increasing its DVA), the absolute deterioration in Bank of Baroda's credit spread is greater, meaning the CVA increase effect dominates the DVA effect.
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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
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