ON THE CVA OF CREDIT DEFAULT SWAPS: THE IMPLICATION OF DEPENDENCE USING A COPULA APPROACH

Abstract

This study examines the nature and background to the Credit Value Adjustment(CVA), a concept that has gained focus due the it’s heightened importance for financial institutions subsequent to the 2008 financial crisis. CVA can be defined as the the price that should be added to the bilateral defaultable contract to adjust for the existing Counterparty Credit Risk (CCR) so that the contract will have the same value as a corresponding risk-free contract. This thesis aims to derive and implement a CVA measure of a Credit Default Swap (CDS) under the presence of Wrong Way Risk (WWR). The Credit Default Swap is roughly an insurance against potential losses suffered from a default of an obligor, typically a company or a sovereign state , often denoted by the reference entity. The CDS contains of the buyer and seller of the CDS, and the reference entity. The buyer of protection has to pay a quarterly payment to the seller of protection, which in turn has to pay a nominal amount to the buyer in the case of default of the reference entity. In this setting, WWR can be defined as the risk of a negative relationship between the reference entity and the sellers credit quality. We are using the semi-analytical expression derived in Herbertsson (2023) to examine CVA under different values parameters correlation and default intensity, which is the default rate for a certain time period conditional on no earlier default. In line with Arismendi-Zambrano et al. (2022), the results show that CVA is increasing with both parameters. An additional two studies are made on the time-series CVA. The first one exhibited an increase in CVA losses during the 08’ crisis and the Europen Debt Crisis. Furthermore, we examine the time-series CVA under different values of correlation which confirmed a positive relationship between them.