Wrong-Way Risk of Interest Rate Instruments

23 Pages Posted: 3 Jun 2019

See all articles by Ramzi Ben-Abdallah

Ramzi Ben-Abdallah

University of Quebec at Montreal - School of Management - Department of Finance

Michèle Breton

HEC Montreal - Department of Management Sciences

Oussama Marzouk

HEC Montreal - Department of Management Sciences

Date Written: May 31, 2019

Abstract

Wrong-way risk (WWR) arises when the value of a financial transaction is adversely correlated with the creditworthiness of the counterparty. This paper investigates WWR effects on the pricing of counterparty credit risk for interest rate instruments. These effects are captured via the correlations between the default of the counterparty and the two relevant market risk factors, namely the level and the volatility of the instantaneous spot interest rate. We consider an interest rate model featuring unspanned stochastic volatility behavior in order to analyze the effects of correlations on both volatility-insensitive instruments (interest rate swaps) and volatility-sensitive products (interest rate caps and floors). We also investigate the impact of correlation on the gap risk in collateralized instruments. Our empirical findings show that the wrong-way effect induced by the dependence between the interest rate volatility and the default intensity is generally small, even for volatility-sensitive derivatives. However, a dependence between the interest rate level and the default intensity has a sizable impact on counterparty risk.

Keywords: counterparty credit risk, wrong-way risk (WWR), gap risk, interest rate volatility, dependence, interest rate derivatives

Suggested Citation

Ben-Abdallah, Ramzi and Breton, Michèle and Marzouk, Oussama, Wrong-Way Risk of Interest Rate Instruments (May 31, 2019). Journal of Credit Risk, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3398187

Ramzi Ben-Abdallah

University of Quebec at Montreal - School of Management - Department of Finance ( email )

315 Sainte-Catherine East
Montreal, Quebec H2X 3X2
Canada
(514) 987-3000 # 2821 (Phone)
(514) 987-0422 (Fax)

Michèle Breton (Contact Author)

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada
514-340-6490 (Phone)
514-340-5634 (Fax)

Oussama Marzouk

HEC Montreal - Department of Management Sciences ( email )

Montreal, Quebec H3T 2A7
Canada

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