CVA/DVA Wrong Way Risk Put into Practice
20 Pages Posted: 1 May 2014 Last revised: 17 Feb 2015
Date Written: February 4, 2015
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: Suggested Citation