Best market practice for calculation and reporting of wrong-way risk

The global financial crisis has illustrated the importance of the correct quantification of counterparty risk that arises from bilateral over-the-counter (OTC) derivative contracts. A significant amount of effort in quantifying counterparty risk by means of credit value adjustment (CVA) and debt value adjustment (DVA) has been the consequence. Regulatory capital requirements under Basel III and accounting standards such as IFRS 13 contain significant provisions for CVA capitalization 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 that is 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 because of largely uncollateralised trades with monoline insurance companies. WWR is also seen by CVA desks in hedging where co-movements between credit spreads and other market variables can lead to losses caused by cross-gamma. 

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