Bounding Wrong-Way Risk in Measuring Counterparty Risk

Paul Glasserman () and Linan Yang ()
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Paul Glasserman: Columbia University
Linan Yang: Columbia University

No 15-16, Working Papers from Office of Financial Research, US Department of the Treasury

Abstract: Counterparty risk measurement integrates two sources of risk: market risk, which determines the size of a firm's exposure to a counterparty, and credit risk, which reflects the likelihood that the counterparty will default on its obligations. Wrong-way risk refers to the possibility that a counterparty's default risk increases with the market value of the exposure. We investigate the potential impact of wrong-way risk in calculating a credit valuation adjustment (CVA) to a derivatives portfolio: CVA has become a standard tool for pricing counterparty risk and setting associated capital requirements. We present a method, introduced in our earlier work, for bounding the impact of wrong-way risk on CVA. The method holds fixed marginal models for market and credit risk while varying the dependence between them. Given simulated paths of the two models, we solve a linear program to find the worst-case CVA resulting from wrongway risk. The worst case can be overly conservative, so we extend the procedure by penalizing deviations of the joint model from a baseline model. By varying the penalty for deviations, we can sweep out the full range of possible CVA values for different degrees of wrong-way risk. Our method addresses an important source of model risk in counterparty risk measurement.

Keywords: credit valuation adjustment; counterparty credit risk; wrong-way risk; iterative proportional fitting process (IPFP) (search for similar items in EconPapers)
Pages: 16 pages
Date: 2015-08-19
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Citations: View citations in EconPapers (4)

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