CVA and Wrong Way Risk

For years, it has been common practice in the ?nancial industry to price deriva- tive portfolios without taking the counterparty credit quality into account. However, the true portfolio value must incorporate the possibility of losses due to default of the counterparty. The adjustment of the value of a \default-free" portfolio to the possibility of counterparty default is known as credit value adjustment (CVA). This dissertation covers introductory aspects in relation to counterparty credit risk and CVA and is aimed at providing ?rst a brief outline of the concept of CVA under regulatory and pricing perspectives. Then, a modelling framework for the computation of CVA capturing Wrong Way risk on a forward contract having as underlying futures oil will be out- lined in detail. Wrong- way risk is the phrase generally used to indicate an unfavourable dependence between exposure and counterparty credit quality: the exposure is high when the counterparty is more likely to default and vice versa. We compare two di?erent approaches to measure CVA incorporating Wrong Way risk. First, we propose a model which assumes the quanti?cation of an exposure conditional on the counterparty's probability of default as a metric exposure. Second, we analyze the model proposed by Hull and White which relates the hazard rate of the counterparty to the value of the transac- tions outstanding between the bank and the counterparty. At the end of this dissertation we outline the relative strengths and weakness of both approaches proposed for capturing Wrong Way risk and we provide a solid basis for further developments on the relative correlation parameters to best determine CVA. Keywords: Counterparty credit risk, CVA, Wrong Way risk, risk manage- ment