medium · FRM Part 2 Credit Risk
A bank's internal model for Credit Value Adjustment (CVA) uses risk-neutral default probabilities bootstrapped from CDS spreads rather than historical default frequencies.
Why is this required by regulatory and accounting standards?
- Historical PDs run systematically higher than risk-neutral PDs, and using them directly for CVA pricing would lead to over-capitalization.
- CVA is a market price for counterparty risk that must be hedgeable using market instruments; historical PDs do not include the market risk premium.
- Risk-neutral PDs are inherently more stable and considerably less prone to the cyclical swings that affect through-the-cycle historical PD estimates.
- Historical default data may only be used to calculate Potential Future Exposure (PFE), and is never permitted for pricing CVA under accounting standards.
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