CVA Wrong Way Risk: Calibration Using Quanto CDS Basis

Abstract

In this article, we discuss the calibration of wrong way risk (WWR) model by using information from the credit default swap (CDS) market. A Quanto CDS provides credit protection against the default of a reference entity but is denominated in a non-domestic currency. The payoff of a Quanto CDS contract therefore reflects the market-implied interaction of FX risk and a credit event. This in turn, defines the cost of hedging WWR for a FX-sensitive portfolio. Our empirical evidence shows that the implied FX jump sizes are significant for a wide range of corporates. For systemic counterparties, the CVA WWR add-on could be 40% higher than the standard case, and choosing a proper jump-at-default WWR model is critical to capture the impact. In contrast, historical correlation gives the incorrect relationship (right-way risk) and cannot calibrate to the market prices in many cases, leading to the mispricing of CVA WWR.

Keywords: credit valuation adjustment, wrong way risk, quanto CDS, FX devaluation

JEL Classification: G1