Technical Note: On Wrong Way Risk

Forthcoming publication in the Journal of Financial Transformation

Wrong Way Risk can be of crucial importance when computing counterparty risk measurements like EPE or PFE profiles. It appears when the default probability a given counterparty is not independent of its portfolio value. There are a number of approaches in the literature but, to the author’s knowledge, they all fail to provide either a computationally efficient approach or an intuitive methodology, or both. This technical note tackles this problem and describes an intuitive and fairly easy method to account for Wrong Way Risk with minimal added computational effort.

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