CVA with wrong-way risk and correlation between defaults: An application to an interest rate swap
DOI:
https://doi.org/10.32826/reyf.v1i3.345Keywords:
Credit risk, Probability of default, Wrong-way risk, Dependency, SwapAbstract
This paper presents a counterparty credit risk adjustment model to value over-the-counter financial derivatives. To do so, a bilateral credit valuation adjustment with wrong-way risk (WWR) and dependency between the defaults of both contract parties is developed in line with the Hull-White model (2012), which calculates default probabilities using a hazard rate modelled as an exponential function dependent on the value of the derivative. The model proposed incorporates a modified hazard rate for each entity, which includes the company’s own exposure to credit risk attributable to the other entity’s default. By so doing, a correlation between the respective defaults of the entities party to the financial derivative is added. The model developed is also applied to obtain the fair value of an interest rate swap and the results obtained, using Monte Carlo simulation, demonstrate that the value of this swap adjusted to the credit risk falls when the dependency between the entities’ defaults is considered.
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