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

15.5 Wrong-way Risk and Credit Derivatives

Credit derivatives need particular attention as they effectively represent an entire asset class of wrong-way risk. Furthermore, the problems with monoline insurers described in Section 6.4.4 illustrate the inherent problems with wrong-way risk and credit derivatives. We will analyse the monoline failure in more detail below and explain how wrong-way risk caused such problems. This is not just a historical note: central counterparties intend to clear a significant portion of the credit derivatives market and will therefore have to deal with this wrong-way risk.

15.5.1 Single-name Credit Derivatives

The wrong-way risk in credit derivatives is a direct consequence of the nature of the products themselves and can lead to serious counterparty risk issues. A protection buyer in a CDS contract has a payoff with respect to a reference entity's default but is at risk in case the counterparty in the contract suffers a similar fate. As mentioned in Section 8.3.6, the CDS product has a highly asymmetric payoff profile due to being essentially an insurance contract. In addition to this, there is also a correlation effect. Buying CDS protection represents a very definite form of wrong-way risk that is made worse as the correlation between the credit quality of the reference entity and the counterparty increases.

In Appendix 15D, we discuss the pricing for a CDS with counterparty risk using a Gaussian copula framework as discussed previously. This requires ...