A subordinated CIR intensity model with application to wrong-way risk CVA

DOI10.1142/S0219024918500450zbMATH Open1417.91530arXiv1801.05673OpenAlexW2963968271MaRDI QIDQ4555855FDOQ4555855

Authors: Cheikh Mbaye, Frédéric Vrins 

Publication date: 23 November 2018

Published in: International Journal of Theoretical and Applied Finance (Search for Journal in Brave)

Abstract: Credit Valuation Adjustment (CVA) pricing models need to be both flexible and tractable. The survival probability has to be known in closed form (for calibration purposes), the model should be able to fit any valid Credit Default Swap (CDS) curve, should lead to large volatilities (in line with CDS options) and finally should be able to feature significant Wrong-Way Risk (WWR) impact. The Cox-Ingersoll-Ross model (CIR) combined with independent positive jumps and deterministic shift (JCIR++) is a very good candidate : the variance (and thus covariance with exposure, i.e. WWR) can be increased with the jumps, whereas the calibration constraint is achieved via the shift. In practice however, there is a strong limit on the model parameters that can be chosen, and thus on the resulting WWR impact. This is because only non-negative shifts are allowed for consistency reasons, whereas the upwards jumps of the JCIR++ need to be compensated by a downward shift. To limit this problem, we consider the two-side jump model recently introduced by Mendoza-Arriaga & Linetsky, built by time-changing CIR intensities. In a multivariate setup like CVA, time-changing the intensity partly kills the potential correlation with the exposure process and destroys WWR impact. Moreover, it can introduce a forward looking effect that can lead to arbitrage opportunities. In this paper, we use the time-changed CIR process in a way that the above issues are avoided. We show that the resulting process allows to introduce a large WWR effect compared to the JCIR++ model. The computation cost of the resulting Monte Carlo framework is reduced by using an adaptive control variate procedure.

Full work available at URL: https://arxiv.org/abs/1801.05673

Recommendations

• CVA with wrong way risk: sensitivities, volatility and hedging
• Disentangling wrong-way risk: pricing credit valuation adjustment via change of measures
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zbMATH Keywords

credit value adjustment (CVA)default intensitytime-changed diffusionadaptive control variateLévy subordinatorwrong-way risk (WWR)

Mathematics Subject Classification ID

Numerical methods (including Monte Carlo methods) (91G60) Credit risk (91G40)

Cites Work

• Lévy Processes and Stochastic Calculus
• Mathematical methods for financial markets.
• Credit default swap calibration and derivatives pricing with the SSRD stochastic intensity model
• On the discretization schemes for the CIR (and Bessel squared) processes
• Interest rate models -- theory and practice. With smile, inflation and credit
• Time-changed CIR default intensities with two-sided mean-reverting jumps
• An exact formula for default swaptions' pricing in the SSRJD stochastic intensity model
• Disentangling wrong-way risk: pricing credit valuation adjustment via change of measures
• WRONG-WAY RISK CVA MODELS WITH ANALYTICAL EPE PROFILES UNDER GAUSSIAN EXPOSURE DYNAMICS
• Conic martingales from stochastic integrals

Cited In (14)

• Affine term structure models: A time‐change approach with perfect fit to market curves
• Disentangling wrong-way risk: pricing credit valuation adjustment via change of measures
• Wrong way risk corrections to CVA in CIR reduced-form models
• CVA and vulnerable options in stochastic volatility models
• A note on empirical analysis for general wrong-way risk and stressed CVA
• Numerical procedures for a wrong way risk model with lognormal hazard rates and Gaussian interest rates
• CVA with wrong way risk: sensitivities, volatility and hedging
• Computing credit valuation adjustment for Bermudan options with wrong way risk
• CVA and vulnerable options pricing by correlation expansions
• Bounding wrong-way risk in CVA calculation
• A note on the double impact on CVA for CDS: wrong-way risk with stochastic recovery
• WRONG-WAY RISK CVA MODELS WITH ANALYTICAL EPE PROFILES UNDER GAUSSIAN EXPOSURE DYNAMICS
• Time-changed CIR default intensities with two-sided mean-reverting jumps
• CVA with Wrong-Way Risk in the Presence of Early Exercise

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