Double Impact on CVA for CDS: Wrong-Way Risk with Stochastic Recovery

Hui Li

MPRA Paper from University Library of Munich, Germany

Abstract: Current CVA modeling framework has ignored the impact of stochastic recovery rate. Due to the possible negative correlation between default and recovery rate, stochastic recovery rate could have a doubling effect on wrong-way risk. In the case of a payer CDS, when counterparty defaults, the CDS value could be higher due to default contagion while the recovery rate may also be lower if the economy is in a downturn. Using our recently proposed model of correlated stochastic recovery in the default time Gaussian Copula framework, we demonstrate this double impact on wrong-way risk in the CVA calculation for a payer CDS. We also present a new form of Gaussian copula that correlates both default time and recovery rate.

Keywords: Counterparty Risk; Credit Valuation Adjustment; Wrong-Way Risk; Default Time Copula; Gaussian Copula; Default Correlation; Stochastic Recovery; Spot Recovery; Credit Default Swap (search for similar items in EconPapers)
JEL-codes: G13 (search for similar items in EconPapers)
Date: 2009-12-31
New Economics Papers: this item is included in nep-ban and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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