Wrong-way risk arises when the value of a financial transaction is adversely correlated with the creditworthiness of the counterparty. This paper investigates wrong-way-risk effects on the pricing of counterparty credit risk for interest-rate instruments. These effects are captured via the correlations between the default of the counterparty and the two relevant market risk factors, namely, the level and the volatility of the instantaneous spot interest rate. Our empirical findings show that the wrong-way effect induced by the dependence between the interest-rate volatility and the default intensity is generally small, even for volatility-sensitive derivatives. However, a dependence between the interest-rate level and the default intensity has a sizeable impact on counterparty risk and gap risk.
Published March 2018 , 25 pages