TY - JOUR
T1 - Relevance of Wrong-Way Risk in Funding Valuation Adjustments
AU - Zwaard, Thomas van der
AU - Grzelak, Lech A.
AU - Oosterlee, Cornelis W.
N1 - Funding Information:
This work has been financially supported by Rabobank . The authors are grateful for valuable discussions with Jasper van der Kroft regarding the contents of this paper. Furthermore, the authors would like to thank the two anonymous referees for their helpful comments and feedback, which contributed to an improvement of the manuscript.
Publisher Copyright:
© 2022 The Author(s)
PY - 2022/10
Y1 - 2022/10
N2 - In March 2020, the world was thrown into financial distress. This manifested itself in increased uncertainty in the financial markets. Many interest rates collapsed, and funding spreads surged significantly, which increased due to the market turmoil. In light of these events, it is essential to understand and model Wrong-Way Risk (WWR) in a Funding Valuation Adjustment (FVA) context. WWR may currently be absent from FVA calculations in banks’ Valuation Adjustment (xVA) engines. However, in this letter, we demonstrate that WWR effects are non-negligible in FVA modelling from a risk-management perspective. We look at the impact of various modelling choices, such as including the default times of the relevant parties, as well as stochastic and deterministic funding spreads. A case study is presented for interest rate derivatives.
AB - In March 2020, the world was thrown into financial distress. This manifested itself in increased uncertainty in the financial markets. Many interest rates collapsed, and funding spreads surged significantly, which increased due to the market turmoil. In light of these events, it is essential to understand and model Wrong-Way Risk (WWR) in a Funding Valuation Adjustment (FVA) context. WWR may currently be absent from FVA calculations in banks’ Valuation Adjustment (xVA) engines. However, in this letter, we demonstrate that WWR effects are non-negligible in FVA modelling from a risk-management perspective. We look at the impact of various modelling choices, such as including the default times of the relevant parties, as well as stochastic and deterministic funding spreads. A case study is presented for interest rate derivatives.
KW - Computational finance
KW - Funding Valuation Adjustment (FVA)
KW - Risk management
KW - Wrong-Way Risk (WWR)
UR - http://www.scopus.com/inward/record.url?scp=85133705562&partnerID=8YFLogxK
U2 - 10.1016/j.frl.2022.103091
DO - 10.1016/j.frl.2022.103091
M3 - Article
SN - 1544-6123
VL - 49
JO - Finance Research Letters
JF - Finance Research Letters
M1 - 103091
ER -