CVA Wrong Way Risk Multiplier Decomposition and Efficient CVA Curve

Journal of Risk Management in Financial Institutions, Vol. 8, No. 4, 390-404 (2015)

27 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: March 23, 2015

Abstract

Credit value adjustment (CVA) is an adjustment added to the fair value of an over-the-counter trade due to the counterparty risk. When the exposure to the counterparty changes in the same direction as the counterparty default risk the so-called wrong-way-risk (WWR) must be taken into account. Calculating CVA with WWR has been a computationally challenging task especially because it has to be done frequently. In this paper, we start with the fact that the ratio of CVA with WWR to CVA under the independent exposure and default assumption depends on the means and standard deviations of exposure and default probability and their linear correlation. The CVA WWR ratio is then decomposed into two factors, a robust correlation and a profile multiplier with further economic insight into the CVA WWR ratio. The distribution free approach in this paper entails an efficient algorithm of curve based CVA WWR calculation. A numerical study illustrates the algorithm and its benefits.

Keywords: Credit value adjustment (CVA), Wrong Way Risk, Right Way Risk, Robust Correlation, CVA Ratio

JEL Classification: G32

Suggested Citation

Pang, Tao and Chen, Wei and Li, Le, CVA Wrong Way Risk Multiplier Decomposition and Efficient CVA Curve (March 23, 2015). Journal of Risk Management in Financial Institutions, Vol. 8, No. 4, 390-404 (2015), Available at SSRN: https://ssrn.com/abstract=2862116

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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