EFFICIENT WRONG-WAY RISK MODELING FOR FUNDING VALUATION ADJUSTMENTS

Thomas van der Zwaard, Lech A. Grzelak and Cornelis W. Oosterlee ()
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Thomas van der Zwaard: Mathematical Institute, Utrecht University, Heidelberglaan 8, 3584 CS Utrecht, The Netherlands2Rabobank, Croeselaan 18, 3521 CB Utrecht, The Netherlands
Lech A. Grzelak: Mathematical Institute, Utrecht University, Heidelberglaan 8, 3584 CS Utrecht, The Netherlands2Rabobank, Croeselaan 18, 3521 CB Utrecht, The Netherlands
Cornelis W. Oosterlee: Mathematical Institute, Utrecht University, Heidelberglaan 8, 3584 CS Utrecht, The Netherlands

International Journal of Theoretical and Applied Finance (IJTAF), 2024, vol. 27, issue 02, 1-43

Abstract: Wrong-Way Risk (WWR) is an important component in Funding Valuation Adjustment (FVA) modeling. Yet, the standard assumption is independence between market risks and the counterparty defaults and funding costs. This typical industrial setting is our point of departure, where we aim to assess the impact of WWR without running a full Monte Carlo simulation with all credit and funding processes. We propose to split the exposure profile into two parts: an independent and a WWR-driven part. For the former, exposures can be re-used from the standard xVA calculation. We express the second part of the exposure profile in terms of the stochastic drivers and approximate these by a common Gaussian stochastic factor. Within the affine setting, the proposed approximation is generic, is an add-on to the existing xVA calculations and provides an efficient and robust way to include WWR in FVA modeling. Case studies for an interest rate swap and a representative multi-currency portfolio of swaps illustrate that the approximation method is applicable in a practical setting. We analyze the approximation error and use the approximation to compute WWR sensitivities, which are needed for risk management. The approach is equally applicable to other metrics such as Credit Valuation Adjustment.

Keywords: Gaussian approximation; Wrong-Way Risk (WWR); Funding Valuation Adjustment (FVA); computational finance; risk management (search for similar items in EconPapers)
Date: 2024
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DOI: 10.1142/S0219024924500109

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