hard · 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 are systematically higher than risk-neutral PDs, leading 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 more stable and less prone to cyclical fluctuations than through-the-cycle PDs.
- Historical data is only allowed for the calculation of Potential Future Exposure (PFE), not CVA.
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