CVA, WWR, Hedging and Bermudan Swaption

by Ali Boukhobza of Grupo Santander, and
Jerome Maetz of Grupo Santander

August 2012

Abstract: "Roughly two-thirds of credit counterparty losses were due to credit valuation adjustment losses and only one-third were due to actual defaults" according to the Basel Committee on Banking Supervision, highlighting the importance of counterparty credit risk management to the derivatives contracts. Today, managing counterparty credit risk has become an integrated part of many derivative trading desks' day-to-day activities and the need of accurate pricing, efficient hedging strategies and practical proxies has become critical. As a result, banks have sharpened their CVA pricing and modeling infrastructure and most have a dedicated trading desk dynamically hedging their CVA.

 However, if pricing techniques have become standard over the past few years, the expected positive exposure (EPE) modeling is usually not taking into account the embedded correlation between the counterparty and underlying market movements. This correlation known as wrong way risk can substantially affect the price and the related hedging strategy and is the main focus of this article.

JEL Classification: C02, G10, G12, G13.

Keywords: CVA, Credit Valuation Adjustment, WWR, Wrong Way Risk, Hedging, Swap, Bermudan Swaption, EPE, Expected Positive Exposure.

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