TITLE:
Modeling and Quantifying of the Global Wrong Way Risk
AUTHORS:
Badreddine Slime
KEYWORDS:
Counterparty Risk, Credit Value Adjustment, Wrong Way Risk, Copulas
JOURNAL NAME:
Journal of Financial Risk Management,
Vol.6 No.3,
August
11,
2017
ABSTRACT: The counterparty risk issue
has become increasingly important in the world of finance. This risk is defined
as the loss due to the counterparty default. The regulator uses the Credit
Value Adjustment (CVA) to measure this risk. However, there is the independency assumption
between the default and the exposure behind the CVA computation and it is not verified on the financial market. This paper
presents two mathematical models for the assessment and the quantification of
the counterparty risk without this assumption. This kind of risk is known as
Wrong Way Risk (WWR). This study focuses on three approaches: empirical, copula and mixed model.
The first one is based on the hazard rate modelling to express the correlation
between the probability of default and the exposure. The second one is about
calculating the WWR effect using copulas. The last one is a combination of both. There is
another assumption that makes easier the CVA computation: The constant of the loss given default (LGD). As we know this assumption is not verified
because the LGD could be deterministic or stochastic. Otherwise, it
could lead to a correlation effect between the LGD, the exposure and the default, and we then obtain a Global Wrong Way
Risk (GWWR). Indeed, we propose a model allowing the CVA quantification without these assumptions.