Identify cases that illustrate collateral exposed to wrong-way risk.
The idea
Collateral is exposed to wrong-way risk when its value is positively related to the posting counterparty's default. The clearest examples are the counterparty's own bonds or shares, bonds of its parent or affiliates, and securities from the same sector, such as oil company shares posted by an oil producer. A bank posting its home government's bonds is a standard illustration, because bank and sovereign credit are linked. So is a firm posting securitisations of loans it originated, and so is a gold miner posting gold. The least exposed collateral is cash in a major currency, or highly rated, liquid, diversified securities with no link to the counterparty. A haircut calibrated to normal volatility will not cover the correlated fall seen at default. Ask what the counterparty's default says about the collateral price.
A practice question
A bank counterparty posts collateral to a dealer. Which collateral is most exposed to wrong-way risk?
- US Treasury bills.Why not: A liquid, highly rated asset whose value is unrelated to the counterparty's default.
- Senior bonds issued by the counterparty itself. - correct
- Cash in a major currency.Why not: Cash has no price risk and no link to the counterparty's credit quality.
- A diversified portfolio of highly rated bonds from different countries.Why not: Diversification across issuers keeps dependence on the counterparty low.
The counterparty's own debt is likely to lose value sharply in the event of its default, so it is poor collateral. Cash and diversified high-grade assets have little such dependence.
A harder one
A bank in a stressed country posts that country's government bonds as collateral to a foreign dealer. The dealer treats this as an example of:
- collateral subject to right-way risk, because the bond price rises when the bank's credit worsens.Why not: Wrong direction: sovereign bond prices fall when the sovereign's credit worsens.
- collateral without wrong-way risk, because government bonds are always risk-free.Why not: Sovereign bonds are not risk-free; domestic-bank and sovereign credit move together.
- collateral without wrong-way risk, because the haircut for government bonds is set by the central bank.Why not: A regulatory or standard haircut does not remove the dependence between the bonds and the posting bank's credit.
- collateral with wrong-way risk, because the bank's and the sovereign's credit quality are closely linked. - correct
Domestic banks are often large holders of their sovereign's debt, and sovereign stress weakens them. Bonds posted by such a bank lose value as it approaches default.
The hardest tier
A gold mining company posts collateral to a dealer against a derivative. Which collateral gives the greatest collateral wrong-way risk?
- Gold bullion, since a price drop weakens the miner and the collateral together. - correct
- Euro cash held at a custodian bank outside the miner's home country.Why not: Cash has no systematic link to the miner's credit quality.
- US Treasury notes, whose price falls when interest rates rise sharply in a crisis.Why not: Rate moves do not systematically coincide with a gold miner's default.
- A basket of investment-grade bonds of consumer-goods companies in the miner's region.Why not: Consumer-goods credit has little systematic link to the gold price.
The miner's credit quality depends on the gold price, so bullion posted as collateral falls in value when the miner is most likely to default, which is the clearest case here.
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.
- Review how collateral bears on 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.