Wrong-Way Risk Adjusted Exposure: Analytical Approximations for Options in Default Intensity Models

Damiano Brigo, Thomas Hvolby and Frédéric Vrins

Chapter 2 in Innovations in Insurance, Risk- and Asset Management:Proceedings of the Innovations in Insurance, Risk- and Asset Management Conference, 2018, pp 27-45 from World Scientific Publishing Co. Pte. Ltd.

Abstract: We examine credit value adjustment (CVA) estimation under wrong-way risk (WWR) by computing the expected positive exposure (EPE) under an equivalent measure as suggested in [1], adjusting the drift of the underlying for default risk. We apply this technique to European put and call options and derive the analytic formulas for EPE under WWR obtained with various approximations of the drift adjustment. We give the results of numerical experiments based on 4 parameter sets, and supply figures of the CVA based on both of the suggested proxys, comparing with CVA based on a 2D-Monte Carlo scheme and Gaussian Copula resampling. We also show the CVA obtained by the formulas from Basel III. We observe that the Basel III formula does not account for the credit-market correlation, while the Gaussian Copula resampling method estimates a too large impact of this correlation. The two proxies account for the credit-market correlation, and give results that are mostly similar to the 2D-Monte Carlo results.

Keywords: Insurance; Actuarial Science; Risk Measure; Reinsurance; Copula; Replicating Portfolio; Bayesian Finance; Risk Classification; Stochastic Dominance; Dynamic Hedging; Autoregressive Hidden Markov Models; Exchange-Traded Funds; Uncertainty Quantification; Fixed Income; Stochastic Processes for Finance (search for similar items in EconPapers)
JEL-codes: G22 G32 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (6)

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