Double Impact on CVA for CDS: Wrong-Way Risk with Stochastic Recovery

Li, Hui (2009): Double Impact on CVA for CDS: Wrong-Way Risk with Stochastic Recovery.

Abstract

Current CVA modeling framework has ignored the impact of stochastic recovery rate. Due to the possible negative correlation between default and recovery rate, stochastic recovery rate could have a doubling effect on wrong-way risk. In the case of a payer CDS, when counterparty defaults, the CDS value could be higher due to default contagion while the recovery rate may also be lower if the economy is in a downturn. Using our recently proposed model of correlated stochastic recovery in the default time Gaussian Copula framework, we demonstrate this double impact on wrong-way risk in the CVA calculation for a payer CDS. We also present a new form of Gaussian copula that correlates both default time and recovery rate.

• Item Type: MPRA Paper
• Language: English
• Keywords: Counterparty Risk, Credit Valuation Adjustment, Wrong-Way Risk, Default Time Copula, Gaussian Copula, Default Correlation, Stochastic Recovery, Spot Recovery, Credit Default Swap
• Subjects: G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing ; Futures Pricing

References

[1] E. Altman (2006): Default Recovery Rates and LGD in the Credit Risk Model and Practice: An Updated Review of the Literature and Empirical Evidence. defaultrisk.com.

[2] S. Assefa, T. Bielecki, S. Crepey and M. Jeanblanc (2009): CVA computation for counterparty risk assessment in credit portfolio. defaultrisk.com.

[3] Basel Committee on Banking Supervision: Strengthening the resilience of banking sector. Bank of International Settlements, December 2009.

[4] N. Bennani and J. Maetz (2009): A Spot Recovery Rate Extension of the Gaussian Copula. defaultrisk.com.

[5] C. Blanchet-Scalliet and F. Patras (2008): Counterparty Risk Valuation for CDS. defaultrisk.com.

[6] D. Brigo and K. Chourdakis (2009): Counterparty Risk for Credit Default Swaps: Impact of spread volatility and default correlation. International Journal of Theoretical and Applied Finance, Vol. 12, No. 7, pp 1007-1026.

[7] D. Brigo and A. Capponi (2009): Bilateral counterparty risk valuation with stochastic dynamic models and application to Credit Default Swaps. defaultrisk.com.

[8] S. Crepey, M. Jeanblanc and B. Zargari (2009): Counterparty Risk on a CDS in a Markov Chain Copula Model with Joint Defaults. defaultrisk.com.

[9] S. Hitier and E. Huber (2009): CDO Pricing: Copula Implied by Risk Neutral Dynamics. defaultrisk.com.

[10] D. Li (2000): On Default Correlation: A Copula Function Approach. Working Paper, Nr. 99-07, RiskMetrics.

[11] H. Li (2008): CVA calculation for CDS on super senior ABS CDO. defaultrisk.com.

[12] H. Li (2009): On Models of Stochastic Recovery for Base Correlation. http://mpra.ub.uni-muenchen.de/17894

[13] H. Li (2009): Extension of Spot Recovery Model for Gaussian Copula. defaultrisk.com.

[14] A. Lipton and A. Sepp (2009): Credit value adjustment for credit default swaps via the structural default model. Journal of Credit Risk, Vol. 5, No. 2, pp 123-146.