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

15.4 Trade-level Wrong-way Risk

We now deal with trade-level wrong-way risk, looking at the different features by asset class. We will illustrate the wide range of wrong-way risk models and the different aspects that are important to consider.

15.4.1 Interest Rates

The relationship between changes in interest rates and default rates have been shown empirically to be generally negative.⁹ This means that low interest rates are likely to be accompanied by higher default rates. This is most obviously explained by central bank monetary policy being to keep interest rates low when the economy is in recession and the default rate high. Such an effect clearly leads to wrong- and right-way risk in interest rate products, which we will analyse through an interest rate swap.

An obvious way to proceed in light of the empirical evidence is to correlate interest rates and credit spreads (hazard rates) in the quantification of the CVA on an interest rate product. Such approaches have commonly been used in credit derivative pricing (e.g., see O'Kane, 2008). The case above corresponds to a negative correlation. We assume a Hull and White (1990) interest rate model¹⁰ with a flat interest rate term structure of 5%. This will give a symmetric exposure profile that will make the wrong- and right-way risk effects easier to identify. We assume a lognormal hazard rate approach so that credit spreads cannot become negative.¹¹ As before, the counterparty CDS spread and recovery rate are 500 bps and 40%, ...