CVA/DVA Wrong Way Risk Put into Practice

20 Pages Posted: 1 May 2014 Last revised: 17 Feb 2015

See all articles by Wolfram Boenkost

Wolfram Boenkost

Lucht Probst Associates GmbH

Wolfgang M. Schmidt

Frankfurt School of Finance & Management

Date Written: February 4, 2015

Abstract

To account for counterparty default risk it is now common to require a credit valuation adjustment (CVA) charge, which is the price of a hypothetical credit derivative that would protect the dealer against counterparty default. The standard CVA approach, which is also advocated by the Basel III rules, ignores potential dependencies between the client's default probability and the exposure at default, which can either be in disadvantage or favor (wrong or right way risk) for the dealer. We propose a CVA formula that accounts for these dependencies and is easily put into practice since it stays closely to the standard simulation based CVA implementations and requires no additional simulation effort. The formula can be generalized to bilateral CVA thereby taking also into account default correlation between the dealer and client. Numerical examples for interest rate swaps, caps and swaptions illustrate the approach.

Keywords: counterparty default, credit valuation adjustment (CVA), debt valuation adjustment (DVA), wrong way risk, correlation

JEL Classification: G13

Suggested Citation

Boenkost, Wolfram and Schmidt, Wolfgang M., CVA/DVA Wrong Way Risk Put into Practice (February 4, 2015). Available at SSRN: https://ssrn.com/abstract=2431162 or http://dx.doi.org/10.2139/ssrn.2431162

Wolfram Boenkost

Lucht Probst Associates GmbH ( email )

Grosse Gallusstr. 9
Frankfurt, 60311
Germany

HOME PAGE: http://www.l-p-a.com

Wolfgang M. Schmidt (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
250
Abstract Views
1,106
rank
131,630
PlumX Metrics