CVA and Wrong Way Risk

by John Hull of University of Toronto, and
Alan White of University of Toronto

July 6, 2012

Abstract: This paper proposes a simple model for incorporating wrong-way and right-way risk into CVA (credit value adjustment) calculations. These are the calculations, involving Monte Carlo simulation, made by a dealer to determine the reduction in the value of its derivatives portfolio because of the possibility of a counterparty default. The model assumes a relationship between the hazard rate of the counterparty and variables whose values can be generated as part of the Monte Carlo simulation. Numerical results for portfolios of 25 instruments dependent on five underlying market variables are presented. The paper finds that wrong-way and right-way risk have a significant effect on the Greek letters of CVA as well as on CVA itself. It also finds that the percentage effect depends on the collateral arrangements.

JEL Classification: G28,G33.

AMS Classification: 91G40.

Keywords: CVA, Wrong way risk, Hazard rate.

Forthcoming in: Financial Analysts Journal.

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