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

Author

Listed:
  • Yifan Yang

    (EDHEC Risk Institute—Asia, One George Street, #07-02, Singapore 049145, Singapore)

  • Frank J. Fabozzi

    (EDHEC Business School, 393, Promenade des Anglais, BP3116, 06202, Nice Cedex 3, France)

  • Michele Leonardo Bianchi

    (Regulation and Macroprudential Analysis Directorate, Bank of Italy, Via Milano 53, 00184, Rome, Italy)

Abstract

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.

Suggested Citation

  • Yifan Yang & Frank J. Fabozzi & Michele Leonardo Bianchi, 2015. "Bilateral counterparty risk valuation adjustment with wrong way risk on collateralized commodity counterparty," Journal of Financial Engineering (JFE), World Scientific Publishing Co. Pte. Ltd., vol. 2(01), pages 1-31.
    • Handle: RePEc:wsi:jfexxx:v:02:y:2015:i:01:n:s2345768615500014
    DOI: 10.1142/S2345768615500014
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    References listed on IDEAS

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    1. Damiano Brigo & Agostino Capponi, 2008. "Bilateral counterparty risk valuation with stochastic dynamical models and application to Credit Default Swaps," Papers 0812.3705, arXiv.org, revised Nov 2009.
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    Cited by:

    1. Erdinc Akyildirim & Alper A. Hekimoglu & Ahmet Sensoy & Frank J. Fabozzi, 2023. "Extending the Merton model with applications to credit value adjustment," Annals of Operations Research, Springer, vol. 326(1), pages 27-65, July.

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