Bilateral counterparty risk valuation adjustment with wrong way risk on collateralized commodity counterparty

Yifan Yang (), Frank Fabozzi () and Michele Leonardo Bianchi ()
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Yifan Yang: EDHEC Risk Institute—Asia, One George Street, #07-02, Singapore 049145, Singapore
Michele Leonardo Bianchi: Regulation and Macroprudential Analysis Directorate, Bank of Italy, Via Milano 53, 00184, Rome, Italy

Journal of Financial Engineering (JFE), 2015, vol. 02, issue 01, 1-31

Abstract: Basel III requires banks to include a credit value adjustment (CVA) into capital charges. Both CVA and debt value adjustment (DVA) must be included for derivatives using mark-to-market accounting. An effective method to calculate bilateral-CVA (BR-CVA) by incorporating wrong-way risk (WWR) for a collateralized counterparty is proposed which handles WWR — defined as when counterparty credit exposure increases as default probability increases — by building a trivariate Gaussian copula between the aggregate market risk exposure factor and default quality of the financial institution and counterparty. This paper extends the ordered-scenario copula model proposed in the literature. It links BR-CVA pricing and WWR, which is close to the current regulatory requirement and useful for managing a financial institution's risk. A practical example is provided. Numerical results suggest that the proposed method is efficient and robust and can easily stress test the impact of WWR in BR-CVA pricing.

Keywords: Wrong-way risk; credit value adjustment; debt value adjustment; counterparty credit risk (search for similar items in EconPapers)
Date: 2015
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DOI: 10.1142/S2345768615500014

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