Toward a Better Estimation of Wrong-Way Credit Exposure

Abstract

In counterparty credit risk management for swaps, forwards, and other derivative contracts, it is recognized that most common applications of credit exposure measures suffer from the deficiency of assuming that counterparty default is independent of the amount exposed. Stress tests are often proposed to handle this deficiency, but stress test measures cannot be applied to pricing and limit setting in the same vein as the standard measures. We introduce a framework to condition standard measures of counterparty exposure on default. The conditional measures thus account for "wrong-way" exposures, but fit naturally into current applications.

JEL Classification: D40, G12, G13