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Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA

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  • Samim Ghamami
  • Lisa R. Goldberg

Abstract

Wrong way risk can be incorporated in Credit Value Adjustment (CVA) calculations in a reduced form model. Hull and White [2012] introduced a CVA model that captures wrong way risk by expressing the stochastic intensity of a counterparty's default time in terms of the financial institution's credit exposure to the counterparty. We consider a class of reduced form CVA models that includes the formulation of Hull and White and show that wrong way CVA need not exceed independent CVA. This result is based on some general properties of the model calibration scheme and a formula that we derive for intensity models of dependent CVA (wrong or right way). We support our result with a stylized analytical example as well as more realistic numerical examples based on the Hull and White model. We conclude with a discussion of the implications of our findings for Basel III CVA capital charges, which are predicated on the assumption that wrong way risk increases CVA.

Suggested Citation

  • Samim Ghamami & Lisa R. Goldberg, 2014. "Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA," Finance and Economics Discussion Series 2014-54, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2014-54
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    References listed on IDEAS

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    1. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," The Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
    2. Samim Ghamami, 2013. "Counterparty Credit Risk," Quantitative Finance, Taylor & Francis Journals, vol. 13(12), pages 1863-1865, December.
    3. Darrell Duffie & Lasse Heje Pedersen & Kenneth J. Singleton, 2003. "Modeling Sovereign Yield Spreads: A Case Study of Russian Debt," Journal of Finance, American Finance Association, vol. 58(1), pages 119-159, February.
    4. Darrell Duffie & Jun Pan & Kenneth Singleton, 2000. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," Econometrica, Econometric Society, vol. 68(6), pages 1343-1376, November.
    5. Bjork, Tomas, 2009. "Arbitrage Theory in Continuous Time," OUP Catalogue, Oxford University Press, edition 3, number 9780199574742.
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    Cited by:

    1. Samim Ghamami, 2015. "Derivatives Pricing under Bilateral Counterparty Risk," Finance and Economics Discussion Series 2015-26, Board of Governors of the Federal Reserve System (U.S.).
    2. Paul Glasserman & Linan Yang, 2015. "Bounding Wrong-Way Risk in Measuring Counterparty Risk," Working Papers 15-16, Office of Financial Research, US Department of the Treasury.
    3. Pascal François & Weiyu Jiang, 2019. "Credit Value Adjustment with Market-implied Recovery," Journal of Financial Services Research, Springer;Western Finance Association, vol. 56(2), pages 145-166, October.
    4. Samim Ghamami & Paul Glasserman, 2016. "Does OTC Derivatives Reform Incentivize Central Clearing?," Working Papers 16-07, Office of Financial Research, US Department of the Treasury.

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    Keywords

    Credit value adjustment; stochastic intensity modeling; wrong way and right way risk; Basel III; counterparty credit risk;
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