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Option-Based Pricing of Wrong Way Risk for CVA

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  • Chris Kenyon
  • Andrew Green

Abstract

The two main issues for managing wrong way risk (WWR) for the credit valuation adjustment (CVA, i.e. WW-CVA) are calibration and hedging. Hence we start from a novel model-free worst-case approach based on static hedging of counterparty exposure with liquid options. We say "start from" because we demonstrate that a naive worst-case approach contains hidden unrealistic assumptions on the variance of the hazard rate (i.e. that it is infinite). We correct this by making it an explicit (finite) parameter and present an efficient method for solving the parametrized model optimizing the hedges. We also prove that WW-CVA is theoretically, but not practically, unbounded. The option-based hedges serve to significantly reduce (typically halve) practical WW-CVA. Thus we propose a realistic and practical option-based worst case CVA.

Suggested Citation

  • Chris Kenyon & Andrew Green, 2016. "Option-Based Pricing of Wrong Way Risk for CVA," Papers 1609.00819, arXiv.org, revised Oct 2021.
    • Handle: RePEc:arx:papers:1609.00819
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    References listed on IDEAS

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    1. Rama Cont & Peter Tankov, 2009. "Constant Proportion Portfolio Insurance In The Presence Of Jumps In Asset Prices," Mathematical Finance, Wiley Blackwell, vol. 19(3), pages 379-401, July.
    2. Patrick Jaillet & Ehud I. Ronn & Stathis Tompaidis, 2004. "Valuation of Commodity-Based Swing Options," Management Science, INFORMS, vol. 50(7), pages 909-921, July.
    3. 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.
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    Cited by:

    1. Janis Müller & Peter N. Posch, 2018. "Wrong-way-risk in tails," Journal of Asset Management, Palgrave Macmillan, vol. 19(4), pages 205-215, July.

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