Systemic Wrong Way Risk (Risk, September 2013)

Michael Pykhtin (Federal Reserve Board)

Alexander Sokol (CompatibL)

In this paper, we discuss a unique type of wrong way risk that arises for systemically important counterparties, which we define as counterparties whose default is capable of affecting the markets. The news of a systemically important counterparty default can cause rapid change of value for many market factors, such as FX rates, credit spreads, equity prices and interest rates. This change is likely to occur before most counterparties of the defaulting firm are able to close out their OTC derivative positions. Since credit exposure is determined by the state of the market at the closeout date, the impact of default on the markets after the news of the impending default, but prior to closeout must to be accounted in PFE and CVA calculations. We called the type of wrong way risk due to systemic impact of counterparty default “systemic wrong way risk”, to distinguish it from general or specific wrong way risk which is applicable to all counterparties.

Related conference presentations

Related research has been presented at several conferences starting in 2011, including:

Modeling Credit Exposure to Systemically Important Counterparties, Michael Pykhtin and Alexander Sokol, RiskMinds Amsterdam 2012 (pdf)

If a dealer defaulted, would anybody notice? Examining the applicability of margin period of risk model assumptions to systemically important counterparties and sovereign crises, Michael Pykhtin and Alexander Sokol, Global Derivatives Barcelona 2012 (pdf)

CVA and PFE for systemically or regionally important counterparties: A jump model for exposure conditional on default, Michael Pykhtin and Alexander Sokol, RiskMinds Geneva 2011 (pdf)