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The Journal of Derivatives

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Article

Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA

Samim Ghamami and Lisa R. Goldberg
The Journal of Derivatives Spring 2014, 21 (3) 24-35; DOI: https://doi.org/10.3905/jod.2014.21.3.024
Samim Ghamami
is an economist at the Board of Governors of the Federal Reserve System in Washington, DC, and a senior researcher at the Center for Risk Management Research at the University of California in Berkeley, CA.
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  • For correspondence: samim.ghamami@frb.gov
Lisa R. Goldberg
is director of research at the Center for Risk Management Research and Adjunct Professor of Statistics at the University of California in Berkeley, CA.
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  • For correspondence: lrg@stat.berkeley.edu
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Abstract

Buyers of OTC derivatives need to be concerned about both market risk from the contract’s underlying asset and credit risk of the derivatives counterparty. Taking counterparty risk into valuation leads to Credit Value Adjustment (CVA), which is now recognized as a necessary factor in the calculation of regulatory capital. Wrong way risk occurs when the counterparty’s credit quality is correlated with the value of the derivative contract, so that the counterparty’s default risk increases just when its liability under the contract goes up. Under Basel III, required capital is increased for wrong way risk. In this article, Ghamami and Goldberg question whether that treatment is appropriate. The authors show that CVA may actually be lower than independent CVA in theory, and they provide a numerical example showing that the parameter values for this to occur in practice are not unreasonable.

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The Journal of Derivatives: 21 (3)
The Journal of Derivatives
Vol. 21, Issue 3
Spring 2014
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Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA
Samim Ghamami, Lisa R. Goldberg
The Journal of Derivatives Feb 2014, 21 (3) 24-35; DOI: 10.3905/jod.2014.21.3.024

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Stochastic Intensity Models of Wrong Way Risk: Wrong Way CVA Need Not Exceed Independent CVA
Samim Ghamami, Lisa R. Goldberg
The Journal of Derivatives Feb 2014, 21 (3) 24-35; DOI: 10.3905/jod.2014.21.3.024
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  • Article
    • Abstract
    • THE HULL AND WHITE STOCHASTIC INTENSITY MODEL OF CVA
    • STOCHASTIC INTENSITY MODELS OF CVA
    • NUMERICAL EXAMPLES
    • REGULATORY TREATMENT OF WRONG WAY RISK
    • CONCLUSION
    • Appendix A
    • Appendix B
    • Appendix C
    • ENDNOTES
    • REFERENCES
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