Correlation and Basel II and III

In this chapter, we discuss the correlation concepts in the Basel accord, which are designed to address the risk management failures which led to the great recession 2007 to 2009. In particular, we address CVAR (credit value at risk), which derives the correlated maximum loss due to credit risk. Surprisingly, the Basel accord applies the simplistic One-Factor Gaussian copula (OFGC) model to calcuate CVAR. Richer, multivariate copulas (discussed in chapter 5) would be more rigorous choice to quantify CVAR. We also address a key topic in today's financial markets, CVA (credit value adjustment). CVA is an adjustment to mitigate credit counterparty risk and includes two types of correlations: 1) general wrong way risk and 2) specific wrong way risk. In addition, we address the new concepts of DVA (debt value adjustment) and FVA (funding value adjustment) and their implementation in the Basel accord.