Best Market Practice for Calculation and Reporting of Wrong-Way Risk

Andrew Aziz, Bob Boetcher, Jon Gregory, Alex Kreinin

The global financial crisis that began in 2007 illustrates the importance of the correct quantification of counterparty risk arising from bilateral over-the-counter (OTC) derivative contracts. There has consequently been a significant amount of effort in quantifying counterparty risk via credit value adjustment (CVA) and debt value adjustment (DVA). Both regulatory capital requirements (Basel III) and accounting standards (IFRS 13) contain significant provisions for CVA capitalisation and reporting. In line with these changes, most banks with material OTC derivative portfolios have some sort of “CVA desk” with the responsibility of pricing and managing CVA.

Wrong-way risk (WWR) is a natural feature, added to the already complex framework for CVA quantification. WWR is a well-known relationship where the exposure to a counterparty is adversely related to that counterparty’s default probability. In the global financial crisis, the potential dangers of WWR were illustrated, for example, when banks lost billions of dollars due to largely uncollateralised trades with monoline insurance companies (see, for example, Gregory 2008). WWR is also seen by CVA desks in hedging where co