Bilateral counterparty risk valuation adjustment with wrong way risk on collateralized commodity counterparty

Journal of Financial Engineering, Volume 2, Issue 1, March 2015

Basel III requires banks to include a credit value adjustment (CVA) into capital charges. Both CVA and debt value adjustment (DVA) must be included for derivatives using mark-to-market accounting. An effective method to calculate bilateral-CVA (BR-CVA) by incorporating wrong-way risk (WWR) for a collateralized counterparty is proposed which handles WWR — defined as when counterparty credit exposure increases as default probability increases — by building a trivariate Gaussian copula between the aggregate market risk exposure factor and default quality of the financial institution and counterparty. This paper extends the ordered-scenario copula model proposed in the literature. It links BR-CVA pricing and WWR, which is close to the current regulatory requirement and useful for managing a financial institution's risk. A practical example is provided. Numerical results suggest that the proposed method is efficient and robust and can easily stress test the impact of WWR in BR-CVA pricing.

Keywords: Wrong-way risk, credit value adjustment, debt value adjustment, counterparty credit risk