Examples of Wrong-Way Risk in CVA Induced by Devaluations on Default

Damiano Brigo and Nicola Pede

Chapter 4 in Innovations in Insurance, Risk- and Asset Management:Proceedings of the Innovations in Insurance, Risk- and Asset Management Conference, 2018, pp 95-115 from World Scientific Publishing Co. Pte. Ltd.

Abstract: When calculating Credit Valuation Adjustment (CVA), the interaction between the portfolio’s exposure and the counterparty’s credit worthiness is referred to as Wrong-Way Risk (WWR). Making the assumption that the Brownian motions driving both the market (exposure) and the (counterparty) credit risk-factors dynamics are correlated represents the simplest way of modeling the dependence structure between these two components. For many practical applications, however, such an approach may fail to account for the right amount of WWR, thus resulting in misestimates of the portfolio’s CVA. We present a modeling framework where a further — and indeed stronger — source of market/credit dependence is introduced through devaluation jumps on the market risk–factors’ dynamics. Such jumps happen upon the counterparty’s default and are a particularly realistic feature to include in case of sovereign or systemically important counterparties. Moreover, we show that, in the special case where the focus is on FX/credit WWR, devaluation jumps provide an effective way of incorporating market information coming from quanto Credit Default Swap (CDS) basis spreads and we derive the corresponding CVA pricing equations as a system of coupled PDEs.

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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