Wrong-way-risk in tails

Abstract

With new regulations like the credit valuation adjustment, the assessment of wrong-way-risk is of utter importance. We analyse the effect of a counterparty’s credit risk and its influence on other asset classes (equity, currency, commodity and interest rate) in the event of extreme market movements like the counterparty’s default. With an extreme value approach, we model the tail of the joint distribution of different asset returns belonging to the above asset classes and counterparty credit risk indicated by changes in CDS spreads and calculate the effect on the expected shortfall when conditioning on counterparty credit risk. We find the conditional expected shortfall to be 2 to 440% higher than the unconditional expected shortfall depending on the asset class. Our results give insights both for risk management and for setting an initial margin for non-centrally cleared derivatives which becomes mandatory in the European Market Infrastructure Regulation.