Relevance of Wrong-Way Risk in Funding Valuation Adjustments

Thomas van der Zwaard; Lech A. Grzelak; Cornelis W. Oosterlee

doi:10.1016/j.frl.2022.103091

Relevance of Wrong-Way Risk in Funding Valuation Adjustments

Thomas van der Zwaard, Lech A. Grzelak, Cornelis W. Oosterlee

Rabobank

Research output: Contribution to journal › Article › Academic › peer-review

Abstract

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.

Original language	English
Article number	103091
Number of pages	8
Journal	Finance Research Letters
Volume	49
DOIs	https://doi.org/10.1016/j.frl.2022.103091
Publication status	Published - Oct 2022

Bibliographical note

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)

Keywords

Computational finance
Funding Valuation Adjustment (FVA)
Risk management
Wrong-Way Risk (WWR)

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1-s2.0-S1544612322003166-mainFinal published version, 1.32 MBLicence: CC BY

Cite this

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title = "Relevance of Wrong-Way Risk in Funding Valuation Adjustments",

abstract = "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{\textquoteright} 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.",

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note = "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: {\textcopyright} 2022 The Author(s)",

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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)

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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)

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VL - 49

JO - Finance Research Letters

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M1 - 103091

ER -

Relevance of Wrong-Way Risk in Funding Valuation Adjustments

Abstract

Bibliographical note

Keywords

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