Credit valuation adjustment and wrong way risk

• Published in: Quantitative finance letters Vol. 1; no. 1; pp. 9 - 15
• Main Author: Cherubini, Umberto
• Format: Journal Article
• Language: English
• Published: Taylor & Francis 01.12.2013
• Subjects: Copula functions; Counterpart risk; Credit valuation adjustment; OTC derivatives; Wrong way risk
• DOI: 10.1080/21649502.2013.808029
• ISSN: 2164-9502

We propose a copula function approach to evaluate credit valuation adjustment (CVA) under the assumption of wrong way risk, that is, dependence between the underlying asset and the default risk of the counter party. The model is applied to interest rate swap contracts that represent a huge share of the worldwide over-the-counter derivatives market. The model extends the seminal Sorensen and Bollier approach that was based on the assumption of independence between market and credit risk. Using copulas grants maximum flexibility with the choice of both term structure and credit risk models, as well as the dependence between the two. Closed-form hedging and pricing formulas are obtained for extreme dependence assumptions and for copula functions of the Fréchet family, that is, mixture copulas of the perfect dependence and the independence copulas. An illustrative application shows that dependence affects both the level and the slope of the CVA spreads.