Relevance of Wrong-Way Risk in Funding Valuation Adjustments

TL;DR

This paper emphasizes the importance of incorporating Wrong-Way Risk into Funding Valuation Adjustments, especially during market turmoil, demonstrating its non-negligible impact through a case study on interest rate derivatives.

Contribution

It highlights the significance of modeling Wrong-Way Risk in FVA calculations and analyzes the effects of different modeling choices on FVA during financial distress.

Findings

WWR effects are significant in FVA during market turmoil

Including default times influences FVA estimates

Stochastic funding spreads impact FVA calculations

Abstract

In March 2020, the world was thrown into financial distress. This manifested itself in increased uncertainty in the financial markets. Many interest rates collapsed, and funding spreads surged significantly, which increased due to the market turmoil. In light of these events, it is essential to understand and model Wrong-Way Risk (WWR) in a Funding Valuation Adjustment (FVA) context. WWR may currently be absent from FVA calculations in banks' Valuation Adjustment (xVA) engines. However, in this letter, we demonstrate that WWR effects are non-negligible in FVA modelling from a risk-management perspective. We look at the impact of various modelling choices, such as including the default times of the relevant parties, as well as stochastic and deterministic funding spreads. A case study is presented for interest rate derivatives.