Effective modeling of wrong way risk, CCR capital, and alpha in Basel II 73 Research Paper www.thejournalofriskmodelvalidation.com 1 Unilateral CVA is defined as the difference between the price of a counterparty portfolio when the potential for counterparty default is ignored and the price when the possibility of a default is included in the analysis. It is essentially the market value of counterparty default risk. Bilateral CVA takes into account both the counterparty's and the bank's own potential to default.

We present a simple adjustment to the single-factor credit capital model, which recognizes the diversification from a multi-factor model. We introduce the concept of a diversification factor at the portfolio level, and show that it can be expressed as a function of two parameters that broadly capture the size (sector) concentration and the average cross-sector correlation. The model further supports an intuitive capital allocation methodology through the definition of marginal diversification factors at the sector or obligor level. We estimate the diversification factor for a family of models, and show that it can be express in parametric form or tabulated for potential regulatory applications and risk management. As a risk management tool, it can be used to understand concentration risk, capital allocation and sensitivities, stress testing, as well as to compute "real-time" marginal risk.