Work

Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA

Year: 2014

Type: article

Abstract: Wrong way risk can be incorporated in Credit Value Adjustment (CVA) calculations in a reduced form model. Hull and White [2012] introduced a CVA model that captures wrong way risk by expressing the stochastic intensity of a counterparty's default time in terms of the financial institution's credit exposure to the counterparty. We consider a class of reduced form CVA models that includes the formulation of Hull and White and show that wrong way CVA need not exceed independent CVA. This result is based on some general properties of the model calibration scheme and a formula that we derive for intensity models of dependent CVA (wrong or right way). We support our result with a stylized analytical example as well as more realistic numerical examples based on the Hull and White model. We conclude with a discussion of the implications of our findings for Basel III CVA capital charges, which are predicated on the assumption that wrong way risk increases CVA.

Source: Finance and Economics Discussion Series

DOI: 10.17016/feds.2014.054

Authors: Samim Ghamami, Lisa R. Goldberg

Institutions: Federal Reserve, Federal Reserve Board of Governors, Goldman Sachs (United States), New York University, University of California, Berkeley

Language: English

Topic: Stochastic processes and financial applications

Subfield: Finance

Field: Economics, Econometrics and Finance

Domain: Social Sciences

Open Access status: diamond

OpenAlex ID: W1505404091

FWCI: 5.491

Cites: 23

Cited by: 15

Related to: 10