Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

15.1 Introduction

The last three chapters have been concerned with valuation of counterparty risk and funding via CVA, DVA and FVA under a key simplifying assumption of no wrong-way risk. Wrong-way risk is the phrase generally used to indicate an unfavourable dependence between exposure and counterparty credit quality – i.e., the exposure is high when the counterparty is more likely to default and vice versa. Whilst it may often be a reasonable assumption to ignore wrong-way risk, its manifestation can be rather subtle and potentially dramatic. In contrast, “right-way” risk can also exist in cases where the dependence between exposure and credit quality is a favourable one. Right-way situations will reduce counterparty risk and CVA.

In this chapter, we will identify causes of wrong-way risk and discuss the associated implications on exposure estimation and quantification of counterparty risk. We will give examples of quantitative approaches used and give specific examples such as forward contracts, options and swaps. We will later discuss wrong-way risk in the credit derivative market and analyse what went so dramatically wrong with CDOs in the global financial crisis. The impact of collateral on wrong-way risk will be analysed and the central clearing implications will be discussed.