Wrong-way risk in credit and funding valuation adjustments

TL;DR

This paper introduces a practical model for quantifying wrong-way risk in credit and funding valuation adjustments, especially during systemic crises, by incorporating tail events beyond linear correlation assumptions.

Contribution

It develops a new model that explicitly accounts for tail risks in CVA and FVA calculations, improving upon traditional correlation-based approaches.

Findings

Model effectively captures tail risks during systemic crises

Application to sovereign default scenarios demonstrates practical relevance

Provides a more comprehensive risk assessment for derivatives pricing

Abstract

Wrong-way risk in counterparty and funding exposures is most dramatic in the situations of systemic crises and tails events. A consistent model of wrong-way risk (WWR) is developed here with the probability-weighted addition of tail events to the calculation of credit valuation and funding valuation adjustments (CVA and FVA). This new practical model quantifies the tail risks in the pricing of CVA and FVA of derivatives and does not rely on a limited concept of linear correlation frequently used in many models. The application of the model is illustrated with practical examples of WWR arising in the case of a sovereign default for the most common interest-rate and foreign exchange derivatives.