When calculating
Credit Valuation Adjustment
(CVA), the
interaction between the portfolio’s exposure and the counter-
party’s credit worthiness is referred to as
Wrong–Way Risk
(WWR). Making the assumption that the Brownian mo-
tions driving both the market (exposure) and the (counter-
party) credit risk–factors dynamics are correlated represents
the simplest way of modelling the dependence structure be-
tween these two components. For many practical applica-
tions, however, such an approach may fail to account for the
right amount of WWR, thus resulting in misestimates of the
portfolio’s CVA. We present a modelling framework where
a further — and indeed stronger — source of market/credit
dependence is introduced through devaluation jumps on the
market risk–factors’ dynamics. Such jumps happen upon the
counterparty’s default and are a particularly realistic feature
to include in case of sovereign or systemically important coun-
terparties. Moreover, we show that, in the special case where
the focus is on FX/credit WWR, devaluation jumps provide an effective way of incorporating market information coming
from quanto Credit Default Swap (CDS) basis spreads and we
derive the corresponding CVA pricing equations as a system
of coupled PDEs.