On the Correlation Approach and Parametric Approach for CVA Calculation

Journal of Risk Model Validation, Vol. 11, No. 3, 49-67.

25 Pages Posted: 1 Nov 2016 Last revised: 20 Jan 2019

See all articles by Tao Pang

Tao Pang

North Carolina State University

Wei Chen

SAS Institute Inc.

Le Li

SAS Institute Inc.

Date Written: February 20, 2017

Abstract

Credit value adjustment (CVA) is an adjustment added to the fair value of an over-the-counter trade due to the risk of counterparty defaults. When the exposure to the counterparty and the counterparty default risk tend to change in the same direction, the so-called wrong-way risk (WWR) must be taken into account. The right-way risk (RWR) takes place when the two factors move in the opposite directions. These two effects are also called directional-way risk (DWR). A lot of efforts have been made to reduce the computational burden to calculate CVA with DWR. The two most popular approaches are the parametric approach and the correlation approach. In this paper we develop a connection between these two approaches. In particular, by decomposing the DWR into a robust correlation coefficient and a profile multiplier, we bring the parametric approach into the correlation approach framework. This study allows us to explain the parameters in the parametric approach. Our results also suggest that the parametric approach can become sensitive when calculating the WWR in certain scenarios. For risk model governance and validation purposes, cautions should be given while using the parametric approach for CVA calculation.

Keywords: Credit Value Adjustment (CVA), Wrong Way Risk, Right Way Risk, Correlation Approach, Parametric Approach

JEL Classification: G32

Suggested Citation

Pang, Tao and Chen, Wei and Li, Le, On the Correlation Approach and Parametric Approach for CVA Calculation (February 20, 2017). Journal of Risk Model Validation, Vol. 11, No. 3, 49-67.. Available at SSRN: https://ssrn.com/abstract=2862085 or http://dx.doi.org/10.2139/ssrn.2862085

Tao Pang (Contact Author)

North Carolina State University ( email )

Hillsborough Street
Raleigh, NC 27695
United States

Wei Chen

SAS Institute Inc. ( email )

100 SAS Campus Drive
Cary, NC 27513-2414
United States

Le Li

SAS Institute Inc. ( email )

100 SAS Campus Drive
Cary, NC 27513-2414
United States

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