Charta is on Google Play: practise on the go. Get the app
Charta

Spell out wrong-way risk and set right-way risk against it.

FRM® Part II · Credit Risk Measurement and Management · CVA · FRM2.CR.20.k

The idea

Wrong-way risk is positive dependence between exposure and the counterparty's default probability. Exposure tends to be high when the counterparty is more likely to default. Right-way risk is the opposite, with exposure low when default is likely. Specific wrong-way risk comes from the nature of a particular trade, for example buying a put on a company's shares from that company. General wrong-way risk comes from broad economic factors that affect both exposure and default. The standard CVA formula assumes independence and uses unconditional expected exposure. Under wrong-way risk, exposure conditional on default exceeds the unconditional figure, so CVA is understated. Under right-way risk it is overstated. Exam point: check the sign of the dependence from the bank's own exposure.

A practice question

From the question bank, with the reason each wrong option is wrong.

Wrong-way risk in counterparty credit risk is best described as:

  1. the tendency for exposure to be low when the counterparty's default probability is high.Why not: Describes right-way risk, the opposite dependence.
  2. the risk that the counterparty's recovery rate is below its historical average.Why not: Confuses wrong-way risk with recovery uncertainty; it concerns dependence between exposure and default.
  3. the tendency for exposure to be high when the counterparty's default probability is high. - correct
  4. the risk that a counterparty defaults on the wrong date relative to the margin call.Why not: Confuses wrong-way risk with settlement or margin timing risk.

Wrong-way risk is positive dependence between exposure and the counterparty's default probability: exposure tends to be largest just when default is most likely.

A harder one

Which of the following is an example of specific (rather than general) wrong-way risk?

  1. A bank buys a put option on a company's shares from that same company. - correct
  2. A bank's exposures are concentrated in one country whose growth slows.Why not: A broad concentration or macro dependence, not a link built into a specific transaction.
  3. A bank faces higher exposures across counterparties when interest rates rise.Why not: A market-wide factor; specific wrong-way risk arises from the legal or economic link between the trade and the counterparty.
  4. A bank's portfolio of swaps is exposed to counterparties that all weaken in a recession.Why not: Describes general wrong-way risk from a macroeconomic factor, not a link inherent in one trade.

Specific wrong-way risk comes from the trade itself: a put on the counterparty's own shares pays out exactly when the counterparty is in distress. General wrong-way risk arises from broad economic factors.

The hardest tier

A bank's model shows an unconditional expected exposure of USD 5 million at a date at which the counterparty has a 4% probability of default and loss given default of 60%. A wrong-way risk analysis shows that the expected exposure conditional on the counterparty defaulting at that date is USD 8 million. By what percentage of the true (wrong-way-adjusted) CVA does the independence assumption understate it at this date?

  1. 37.5% - correct
  2. 60.0%Why not: Measures the uplift relative to the independent figure rather than the shortfall relative to the true one.
  3. 2.4%Why not: Scales the exposure uplift by the default probability, mixing a ratio with a probability.
  4. 15.0%Why not: Applies the recovery rate to the shortfall; loss given default cancels in the ratio.

CVA (independent) = 0.6 x 0.04 x 5 = 0.120; CVA (conditional) = 0.6 x 0.04 x 8 = 0.192. The independent figure is 37.5% too low (the true CVA is 60% higher).

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in CVA