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Double Impact on CVA for CDS: Wrong-Way Risk with Stochastic Recovery

by Hui Li of AIG

January 18, 2010

Abstract: Current CVA modeling framework has ignored the impact of stochastic recovery rate. Due to the possible negative correlation between default and recovery rate, stochastic recovery rate could have a doubling effect on wrong-way risk. In the case of a payer CDS, when counterparty defaults, the CDS value could be higher due to default contagion while the recovery rate may also be lower if the economy is in a downturn. Using our recently proposed model of correlated stochastic recovery in the default time Gaussian copula framework, we demonstrate this double impact on wrong-way risk in the CVA calculation for a payer CDS. We also present a new form of Gaussian copula that correlates both default time and recovery rate.

JEL Classification: G13.

Keywords: Counterparty Risk, Credit Valuation Adjustment, Wrong-Way Risk, Default Time Copula, Gaussian Copula, Default Correlation, Stochastic Recovery, Spot Recovery, Credit Default Swap.

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