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Wrong-way Risk in Credit Valuation Adjustment of Credit Default Swap with Copulas

Author

Listed:
  • Tetsuya Adachi

    (Economist, Institute for Monetary and Economic Studies, Bank of Japan (currently, PwC Consulting LLC, E-mail: tetsuya. adachi@pwc.com))

  • Takumi Sueshige

    (Senior, EY Shinnihon LLC (currently, School of Computing, Tokyo Institute of Technology, E-mail: sueshige.t.aa@m.titech.ac.jp))

  • Toshinao Yoshiba

    (Director and Senior Economist, Institute for Monetary and Economic Studies (currently, Financial System and Bank Examination Department), Bank of Japan (E-mail: toshinao.yoshiba@boj.or.jp))

Abstract

We compare several wrong-way risk models for the credit valuation adjustment of a credit default swap under a copula approach with stochastic default intensities. We show that the tail dependent copulas well capture the wrong-way risk for the credit valuation adjustment. To that end, we employ an affine jump diffusion process for the default intensity to derive the distribution function of the cumulative intensity, based on the copula approach. To reduce computing time, we propose an approximation method using the fractional fast Fourier transform and numerical integration to the characteristic function of the cumulative intensity.

Suggested Citation

  • Tetsuya Adachi & Takumi Sueshige & Toshinao Yoshiba, 2019. "Wrong-way Risk in Credit Valuation Adjustment of Credit Default Swap with Copulas," IMES Discussion Paper Series 19-E-01, Institute for Monetary and Economic Studies, Bank of Japan.
    • Handle: RePEc:ime:imedps:19-e-01
    as

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    File URL: https://www.imes.boj.or.jp/research/papers/english/19-E-01.pdf
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    References listed on IDEAS

    as
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    2. Robert A. Jarrow & David Lando & Fan Yu, 2008. "Default Risk And Diversification: Theory And Empirical Implications," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 19, pages 455-480, World Scientific Publishing Co. Pte. Ltd..
    3. 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.
    4. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," The Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    5. Tetsuya Adachi & Yoshihiko Uchida, 2015. "Variation of Wrong-Way Risk Management and Its Impact on Security Price Changes," IMES Discussion Paper Series 15-E-11, Institute for Monetary and Economic Studies, Bank of Japan.
    6. Roger Lord, 2010. "Comment on: A Note on the Discontinuity Problem in Heston's Stochastic Volatility Model," Applied Mathematical Finance, Taylor & Francis Journals, vol. 17(4), pages 373-376.
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    8. Damiano Brigo & Kyriakos Chourdakis, 2009. "Counterparty Risk For Credit Default Swaps: Impact Of Spread Volatility And Default Correlation," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 12(07), pages 1007-1026.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Credit valuation adjustment; Credit default swap; Affine jump diffusion; Fractional fast Fourier transform; Characteristic function;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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