CVA study highlights scale and causes of wrong-way risk

​​​​​​​Researchers advise including correlations both with rate level and volatility in CVA calculations

Crisis-era data on interest rate derivatives shows that wrong-way risk has a significant impact on their pricing, but the effect is almost entirely driven by the level of underlying interest rates rather than their volatility, according to forthcoming research.

Wrong-way risk arises when the exposure to a counterparty grows together with the risk of the counterparty’s default. In contrast to right-way risk, it amplifies the credit valuation adjustment (CVA) component of a derivative’s price.