Wrong-way risk, credit and funding

The risk of exposure and counterparty default probability both increasing – so-called wrong-way risk – is usually understood in terms of the correlation between the two variables. But this approach is focused more on the centre of the distribution, and provides little control over tail events. Mihail Turlakov argues a scenario approach captures the risk better

The financial crisis that followed the collapse of Lehman Brothers in 2008 ushered in a greater focus on counterparty credit risk, and brought terms such as credit, and more controversially debit and funding, valuation adjustments (CVA, DVA and FVA) into the mainstream. These attempt to price the expected mark-to-market (MtM) losses or gains from either party’s default, and the costs of funding the positions. The most dangerous manifestation of counterparty risk comes when the default