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

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15.3 Portfolio Wrong-way Risk

Broadly speaking wrong-way risk can be divided into two categories, namely general and specific. This distinction has been made by the Basel committee in regulatory capital rules (see Chapter 17). General wrong-way risk can be thought of as the general relationship between exposure and default probability due to macroeconomic factors, which is most relevant at the portfolio level. Specific wrong-way risk may be analysed more at the transaction level and often represents more of a structural relationship between the counterparty default probability and the underlying exposure. We will discuss them along similar lines but use the terms portfolio and trade-level wrong-way risk, which do not necessarily coincide with the terms general and specific.

15.3.1 Correlation Approach

The simple approach described in Section 15.2.6 above can readily be extended to the general case. To do this it is necessary to map the exposure distribution at each point in time onto a chosen (e.g., normal) distribution. The most obvious way to do this is to sort the exposures in descending order (although other more complex approaches can be used, as discussed below) and then map via a quantile mapping procedure. The approach is described in more detail in Appendix 15A. This approach is then the simplest version of the approaches proposed by Garcia-Cespedes et al. (2010) and Sokol (2010) and is illustrated in Figure 15.4. Due to the mapping of the exposures onto a normal distribution, ...

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