I'm not claiming this is true or has been done. Just curious about a hypothetical that crossed my mind while reading some old credit risk papers.
In the standard structural model for vulnerable options (Klein 1996), the price of a call written by a risky counterparty depends heavily on the correlation between the underlying asset and the counterparty's total asset value. That correlation is a free parameter. You have to estimate it, and it's notoriously hard to pin down, but it drives the credit charge.
How big of a deal would it be, if this correlation parameter could be derived endogenously from some model's own structure, instead of needing a separate historical estimation.
I'm just asking, if that were true, how much would it matter?
· Would trading desks actually change how they price or hedge OTC options?
· Would CVA calculations become more reliable, or would people still fudge it because they don't trust the inputs?
· Could it create arbitrage opportunities if the market were still pricing options using ad‑hoc correlations?
· How would regulators react if wrong‑way risk suddenly had an objective, model‑determined metric instead of a discretionary one?
· Is this the sort of thing that would just be a nice theoretical footnote, or could it actually reshape how counterparty credit risk is managed in practice?
I would also like some thoughts from people in the field.