Impact of wrong-way risk on margin valuation adjustment

Thesis

Valuation adjustments (XVA) have grown in popularity and importance since the Financial Crisis. In the post-Crisis environment, the value of a derivative can no longer be calculated simply as the risk-free price from by Black-Scholes theory, but other aspect, such as credit risk need to be accounted for as well. New regulations following the Crisis impose collateral requirements on over-the-counter derivatives, where initial and variation margin must be exchanged between trading counterparties. This introduces valuation adjustments that reflect the cost of funding for the derivative position. In particular, the Margin Valuation Adjustment (MVA) quantifies the cost of posting initial margin over the life of a trade.

Over the years, an XVA framework was established as market standard which neglects the correlation structure between the probability of default of the counterparty on the one hand, and the exposure or collateral measure on the other hand. Wrong-way risk, i.e., the situation in which exposure is adversely correlated with the counterparty's default probability has increasingly become a concern for regulators, which started to give recommendations to financial institutions to identify and observe the wrong-way risk present in their portfolios.

This work combines the timely subjects of MVA and wrong-way risk by including wrong-way risk effects in MVA calculations. A model-independent approach is followed that has recently been applied to the calculation of regulatory and accounting Credit Valuation Adjustment and Funding Valuation Adjustment.Sample calculations are performed for plain-vanilla interest-rate swaps, cross-currency swaps, and European swaptions.

Authors: Binder, S

• DOI: 10.5287/ora-g2vwm6nyj
• Type of award: MSc
• Level of award: Masters
• Awarding institution: University of Oxford
• Language: English
• Keywords: wrong-way risk; margin valuation adjustment
• Subjects: Risk management; Finance