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Double Impact on CVA for CDS: Wrong-Way Risk with Stochastic Recovery

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  • Li, Hui
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    Abstract

    Current CVA modeling framework has ignored the impact of stochastic recovery rate. Due to the possible negative correlation between default and recovery rate, stochastic recovery rate could have a doubling effect on wrong-way risk. In the case of a payer CDS, when counterparty defaults, the CDS value could be higher due to default contagion while the recovery rate may also be lower if the economy is in a downturn. Using our recently proposed model of correlated stochastic recovery in the default time Gaussian Copula framework, we demonstrate this double impact on wrong-way risk in the CVA calculation for a payer CDS. We also present a new form of Gaussian copula that correlates both default time and recovery rate.

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    Bibliographic Info

    Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 19684.

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    Date of creation: 31 Dec 2009
    Date of revision: 18 Jan 2010
    Handle: RePEc:pra:mprapa:19684

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    Related research

    Keywords: Counterparty Risk; Credit Valuation Adjustment; Wrong-Way Risk; Default Time Copula; Gaussian Copula; Default Correlation; Stochastic Recovery; Spot Recovery; Credit Default Swap;

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    References

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    1. Damiano Brigo & Agostino Capponi, 2008. "Bilateral counterparty risk valuation with stochastic dynamical models and application to Credit Default Swaps," Quantitative Finance Papers 0812.3705, arXiv.org, revised Nov 2009.
    2. 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.
    3. Li, Hui, 2009. "Extension of Spot Recovery Model for Gaussian Copula," MPRA Paper 17944, University Library of Munich, Germany.
    4. Christophette Blanchet-Scalliet & Fr\'ed\'eric Patras, 2008. "Counterparty risk valuation for CDS," Quantitative Finance Papers 0807.0309, arXiv.org.
    5. Li, Hui, 2009. "On Models of Stochastic Recovery for Base Correlation," MPRA Paper 15750, University Library of Munich, Germany, revised 15 Oct 2009.
    6. Li, Hui, 2008. "CVA calculation for CDS on super senior ABS CDO," MPRA Paper 17945, University Library of Munich, Germany.
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    Cited by:
    1. Li, Hui, 2010. "Downturn LGD: A Spot Recovery Approach," MPRA Paper 20010, University Library of Munich, Germany, revised 18 Jan 2010.

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