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Aug 20

CVA and Wrong-Way Risk

Posted by abiao at 12:17 | Paper Review | Comments(2) | Reads(12250)
CVA (credit value adjustment) is a hot topic, thanks to the financial crisis.  It is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk. Check Wikipedia for its detail definition.

A paper "CVA and Wrong-Way Risk" by John Hull and Alan White published in the Financial Analysts Journal uses Monte Carlo simulation to demonstrate the CVA calculation via a simple model.
This paper proposes a simple model for incorporating wrong-way and right-way risk into CVA (credit value adjustment) calculations. These are the calculations, involving Monte Carlo simulation, made by a dealer to determine the reduction in the value of its derivatives portfolio because of the possibility of a counterparty default. The model assumes a relationship between the hazard rate of the counterparty and variables whose values can be generated as part of the Monte Carlo simulation. Numerical results for portfolios of 25 instruments dependent on five underlying market variables are presented. The paper finds that wrong-way and right-way risk have a significant effect on the Greek letters of CVA as well as on CVA itself. It also finds that the percentage effect depends on the collateral arrangements.

Article, Working paper.

I learned a lot about CVA from reading your blog, thanks for the information you shared.

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