CVA the wrong way

Abstract

The credit valuation adjustment (CVA) has become an integral part of accounting rules and Basel III. The case where the counterparty exposure increases when its credit quality deteriorates is commonly referred as wrong-way risk (WWR). WWR can have a significant impact on CVA, economic capital and collateralised exposures with margins. A robust method is presented to calculate CVA with WWR that is intuitive, easy to implement and computationally efficient. The methodology effectively leverages existing ‘pre-computed’ exposures into a joint market and credit risk portfolio model, which allows the performance of multiple CVA calculations for sensitivities, stress testing and value-at-risk (VaR). It further provides a model risk framework for assessing both general and idiosyncratic WWR, and stress testing both the factors driving correlations as well as the strength of the correlations. The approach is demonstrated through a practical example. While the impact of WWR at the counterparty level can be very significant, the effect of general WWR at the portfolio level may not be as strong for well balanced, large portfolios of derivatives. Furthermore, the standardised charge in Basel III can be significant even when compared against very conservative internal models with WWR.