Identify illustrations of right-way risk as well as wrong-way risk.
The idea
Wrong-way risk examples start with buying a put on a company's shares from that company, because the put pays when the issuer is distressed. Another is a forward where a bank in an emerging market pays dollars against local currency, since devaluation raises the dealer's exposure and stresses the bank. A third is buying CDS protection from a seller whose credit is linked to the reference entity, such as a domestic bank selling protection on its own sovereign. Right-way risk examples come from a company that hedges genuinely, such as an airline buying oil forward or an oil producer selling forward, because the dealer is owed money when the client's credit is stronger. Speculating or over-hedging can reverse the dependence. Ask in which state the bank is owed money and how healthy the counterparty is then.
A practice question
A bank buys a put option on a company's shares from that same company. Which description is correct from the bank's perspective?
- No wrong-way risk, because option exposures are always positive and independent of default.Why not: Overlooks that the option payoff and issuer default share the same driver.
- Right-way risk, because the option is a long position and the bank holds an asset.Why not: Treats being long an asset as right-way; the link between the payoff and default is what matters.
- Right-way risk, because a falling share price increases the company's incentive to honour the option it sold.Why not: Invents a behavioural link; distress lowers the issuer's ability to pay.
- Wrong-way risk, because the put is most valuable when the shares fall, when the company is likeliest to default. - correct
The put pays when the issuer's shares drop, exactly when its credit is weakest, so exposure and default probability rise together.
A harder one
A dealer enters a forward with a bank domiciled in an emerging-market country in which the bank pays US dollars to the dealer and receives the local currency. The local currency is prone to sharp devaluation in a banking crisis. How should the dealer view its credit exposure to this bank?
- As right-way risk: a devaluation makes the bank's local-currency position more valuable to the bank itself.Why not: The bank is short dollars; a devaluation raises its cost of paying, hurting it, so the link is adverse for the dealer.
- As wrong-way risk: a devaluation raises the value of the dollars owed to the dealer and stresses the local bank. - correct
- As no dependence: exchange rates and bank credit quality are independent in emerging markets in general.Why not: Ignores the well-documented link between local currency crises and banking stress.
- As right-way risk: the dealer is owed dollars, a strong currency, which lowers exposure.Why not: Treats the strength of the currency as reducing exposure; the exposure is the forward's positive value, which rises with devaluation.
The forward gains for the dealer when the local currency falls, and a currency fall in a local crisis weakens the bank that must pay in dollars. Exposure and default probability rise together.
The hardest tier
A dealer is assessing four uncollateralised forward trades on oil with different clients. Which is an example of right-way risk for the dealer?
- An oil producer buys oil forward from the dealer on a speculative basis.Why not: If oil falls, the producer owes the dealer while its revenue falls; wrong-way risk.
- An airline sells oil forward to the dealer, beyond its fuel needs, so it is speculating on lower prices.Why not: If oil rises, the airline owes the dealer while its costs rise too; this is wrong-way risk.
- An oil producer sells forward to the dealer an amount below its expected production, as a hedge. - correct
- A bank sells oil forward to the dealer with no connection to the oil market.Why not: The link to oil is absent; the trade has little dependence either way.
A genuine hedger's credit improves when the hedged variable moves against the hedge, so the dealer is owed money when the client is stronger. Over-hedging or speculating reverses the dependence.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in CVA
- Account for why pricing counterparty risk is wanted and what makes it hard.
- Explain the concept of CVA, the adjustment made to a derivative's value for credit risk.
- Work out CVA, plus its expression as a spread, in the simple setting where wrong-way risk, netting and collateralization are all absent.
- Judge how shifts in credit spread and recovery rate assumptions affect CVA.
- Describe bilateral CVA (BCVA) together with debt value adjustment (DVA).
- Account for how unilateral CVA (UCVA) differs from BCVA, and how unilateral DVA (UDVA) differs from BCVA.
- Work out the DVA and the BCVA, then restate BCVA as a spread.
- Explain the way netting enters the computation of CVA.
- State what incremental CVA and marginal CVA are, compute them and show how CVA is turned into a running spread.
- Show how the CVA figure changes once collateralization is built in, paying attention to initial margins, thresholds and the margin period of risk.
- Spell out wrong-way risk and set right-way risk against it.
- Review how collateral bears on wrong-way risk.
- Identify cases that illustrate collateral exposed to wrong-way risk.
- Weigh up how wrong-way risk bears on CCPs (central counterparties).
- Outline the methods for modelling wrong-way risk: hazard rate, structural, parametric and jump approaches.
- Account for what central clearing means for wrong-way risk.