A NOTE ON THE DOUBLE IMPACT ON CVA FOR CDS: WRONG-WAY RISK WITH STOCHASTIC RECOVERY

Hui Li ()
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Hui Li: 13 Old Kings Hwy, Old Greenwich, CT 06870, USA

International Journal of Theoretical and Applied Finance (IJTAF), 2013, vol. 16, issue 03, 1-14

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 credit risk; CVA; CDS; wrong-way risk; stochastic recovery (search for similar items in EconPapers)
Date: 2013
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Citations: View citations in EconPapers (2)

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DOI: 10.1142/S0219024913500131

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