Next, we examine the impact of wrong way risk. Wrong way risk occurs
when exposure to a counterparty is adversely correlated with the credit
quality of that counterparty, while right way risk occurs when exposure
to a counterparty is positively correlated with the credit quality of
that counterparty. Wrong/right way risk, as an additional source of
risk, is rightly of concern to banks and regulators.
Some financial markets are closely interlinked, while others are not.
For example, CDS price movements have a feedback effect on the equity
market, as a trading strategy commonly employed by banks and other
market participants consists of selling a CDS on a reference entity and
hedging the resulting credit exposure by shorting the stock. On the
other hand, Moody’s Investor’s Service (2000) presents statistics that
suggest that the correlations between interest rates and CDS spreads are
very small.
To capture wrong/right way risk, we need to determine the dependency
between counterparties and to correlate the credit spreads or hazard
rates with the other market risk factors, e.g. equities, commodities,
etc., in the scenario generation.
We use an equity swap as an example. Assume the correlation between the
underlying equity price and the credit quality (hazard rate) of partyB is. The impact of the correlation on the CVA is show in Table
5. The results say that the CVA increases when the absolute value of the
negative correlation increases.