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

15.6 Summary

In this chapter we have discussed wrong-way counterparty risk, which is a phenomenon caused by the dependence between exposure and default probability. Wrong-way risk is a subtle, but potentially devastating, effect that can increase counterparty risk and CVA substantially. Portfolio and trade-level wrong-way risk have been described. We have examined some classic examples arising in different asset classes (interest rates, FX, equity and commodities) and associated quantitative approaches. Counterparty risk in credit derivatives has been analysed and the failure of CDOs has been linked to this. Finally, we have considered the impact of wrong-way risk on collateral and argued that it represents a very serious concern for central counterparties.

In the next and final section of this book, we will turn our attention to methods for managing counterparty credit risk including hedging, capital and the operation of a CVA desk.

Notes

1. It is, of course, 25% from one-half times one-half.

2. On the English BBC TV science programme Q.E.D. in 1993.

3. Matthews (1995) has shown that a butter-down landing is indeed more likely, but for reasons of gravitational torque and the height of tables rather than Murphy's Law.

4. A classic example of this is as follows. Suppose a variable X follows a normal distribution. Now choose Y = X². X and Y have zero correlation but are far from independent.

5. We note that there are other ways to represent this effect. For example, we could instead ...