Review how collateral bears on wrong-way risk.
The idea
Collateral reduces the effect of wrong-way risk, because daily margin calls limit how far exposure can build up while a counterparty weakens. It does not remove it. Residual risks are threshold and minimum transfer amounts, the margin period of risk, which allows a gap between the last call and close-out, and jumps at default such as a sudden devaluation. Collateral can also carry wrong-way risk itself. If its value falls when the counterparty's credit falls, as with the counterparty's own bonds or shares, it loses value exactly when the bank needs it. Responses include larger haircuts for correlated collateral, eligibility restrictions and concentration limits. Exam point: separate wrong-way risk in the exposure from wrong-way risk in the collateral.
A practice question
How does collateral generally affect the impact of wrong-way risk on counterparty exposure?
- It reduces the impact, since margin calls limit exposure build-up as the counterparty weakens, but does not remove it. - correct
- It increases wrong-way risk, because collateral calls cause the counterparty to default sooner and raise exposure.Why not: Reverses the effect for the general case; margin calls usually reduce exposure.
- It has no effect, because wrong-way risk concerns default probability and not exposure.Why not: Wrong-way risk is about the dependence of exposure and default; collateral directly reduces exposure.
- It eliminates wrong-way risk, because the exposure is always fully covered by collateral.Why not: Overstates collateral's effect: delays, thresholds and collateral value changes leave residual exposure.
Daily margin keeps exposure close to the threshold plus the move over the margin period, so exposure cannot grow unchecked when the counterparty weakens. Gap, threshold and collateral-quality risks remain.
A harder one
A dealer faces a sovereign-linked counterparty on a currency forward. The CSA calls daily collateral in cash dollars. A sudden devaluation accompanies default. Why does collateral still fail to remove the dealer's wrong-way risk?
- Collateral reduces only the counterparty's default probability, not the exposure, so the jump is passed through in full.Why not: Collateral reduces exposure and loss given default, not the probability of default.
- Cash collateral in dollars always falls in value when a local currency devalues, since the dollar is linked to it.Why not: Dollar cash does not fall in value when a local currency devalues; the jump is in the exposure.
- Daily margin calls cannot be enforced against sovereign-linked counterparties, because the sovereign controls payment systems.Why not: Enforcement is not the issue; the issue is that value can jump faster than margin is exchanged.
- Exposure can jump on devaluation between the last margin call and close-out, a gap the collateral does not cover. - correct
Collateral reflects values as of the last call. A jump at default (such as a devaluation) increases exposure faster than margin can follow, so a gap remains, which is the central limitation of collateral against wrong-way risk.
The hardest tier
A bank has an exposure of USD 50 million to a counterparty and holds the counterparty's own shares, valued at USD 50 million with no haircut, as collateral. When the counterparty defaults, its shares fall 60%. The bank recovers 40% of any remaining unsecured claim. The bank's loss, closest to, is:
- USD 30 millionWhy not: Ignores the recovery on the unsecured claim, so the whole shortfall is lost.
- USD 12 millionWhy not: Applies the recovery rate where the loss given default (1 - R) should apply, so it counts the recovered amount as the loss.
- USD 18 million - correct
- USD 0 millionWhy not: Assumes the collateral keeps its full value, ignoring the fall in the counterparty's own shares at default.
Collateral after the fall = 50 x (1 - 0.60) = 20. Shortfall = 50 - 20 = 30. Loss = 30 x (1 - 0.40) = USD 18 million.
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.
- Identify illustrations of right-way risk as well as 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.