Wrong Way Risk Modeling and Computation in Credit Valuation Adjustment for European and Bermudan Options

We study the impact of wrong-way-risk (WWR) on credit valuation adjustment (CVA) for European and Bermudan options, based on an intensity model. WWR is modeled by a dependency between the underlying asset and the intensity of the counterparty’s default. We consider three different models. We take the difference between the default-free value and the default-adjusted value for the purpose of the CVA calculations. Two numerical algorithms, the COS method and the Stochastic Grid Bundling Method (SGBM) are generalized and employed for the computations. By varying correlation coefficients, we perform a CVA stress test for European options, show differences in the optimal exercise boundaries, in corresponding Bermudan option values and compute the CVA shortfall.