CVA Tail Risk and the Impact of Wrong Way Trades
Journal of Risk Management in Financial Institutions 6(3), 2013
Posted: 28 Mar 2013
Date Written: January 25, 2013
Actively pricing and hedging CVA has quickly emerged as a core function in banks. One of the major functions of the CVA desk is to risk manage CVA. It is well known that wrong way risk has a significant impact on both CVA itself, as well as on the CVA sensitivites (i.e., the Greeks). This means that wrong way risk can significantly impact the CVA desk hedging strategy. While wrong way risk may have a significant impact on CVA and CVA sensitivity, it is natural to expect that the effect on the tail risk of CVA, and hence the required capital, is even greater. This is an important consideration for the CVA desk as tail risks typically remain unhedged in practice and need to bear capital. In addition, to the extent that a CVA desk tries to hedge some tail risk, this is frequently done in the form of out-of-the money options on either the market instruments (interest rates, FX, etc.) or credit instruments (CDS index or tranches). Since these instruments don't capture the wrong-way risk dynamic (they don't have both the market and credit component), they typically are not suitable for completely offsetting the wrong-way risk in the CVA book. This paper analyzes the impact of wrong way risks on both CVA itself as well as on the tail risks of CVA. We demonstrate that the induced tail risk adjustment to account for wrong way risk can be more significant than the impact on CVA itself. Hence, the CVA capital impact of wrong way risk can be larger than the CVA pricing impact of the wrong way risk.
Keywords: Counterparty credit risk, CVA, Wrong way risk
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