Relevance of Wrong-Way Risk in Funding Valuation Adjustments

March 2020, the world was thrown into a period of financial distress. This manifested through increased uncertainty in the financial markets. Many interest rates collapsed and funding spreads surged significantly, which increased due to the market turmoil. In light of these events, it is key to unde...

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Bibliographic Details
Published inIDEAS Working Paper Series from RePEc
Main Authors van der Zwaard, T, Grzelak, L A, Oosterlee, C W
Format Paper
LanguageEnglish
Published St. Louis Federal Reserve Bank of St. Louis 01.01.2022
Subjects
Funding
Valuation
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Summary:March 2020, the world was thrown into a period of financial distress. This manifested through increased uncertainty in the financial markets. Many interest rates collapsed and funding spreads surged significantly, which increased due to the market turmoil. In light of these events, it is key to understand and model Wrong-Way Risk (WWR) in a Funding Valuation Adjustment (FVA) context. WWR might currently not be incorporated in FVA calculations in banks' Valuation Adjustment (xVA) engines. However, we demonstrate that WWR effects are non-negligible in FVA modeling from a risk-management perspective. We look at the impact of various modeling choices such as including the default times of the relevant parties and we consider different choices of funding spread. A case study is presented for interest rate derivatives.