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FRM Exam Part II · Credit Derivatives

Risks and Counterparty Issues in Credit Derivatives

Updated 11 October 2026 · Fact-checked

Credit derivatives move credit risk but add new risks. Counterparty risk is the chance your CDS seller fails. Wrong-way risk is when that failure is most likely just when the CDS pays. Basis risk is a hedge mismatch. Central clearing cuts bilateral risk but concentrates it in the CCP. Solve questions by identifying the risk, its driver and the mitigant.

Understand Risks and Counterparty Issues in Credit Derivatives

A credit default swap (CDS) lets a protection buyer pass the default risk of a reference entity to a protection seller. The buyer pays a periodic spread. The seller pays the loss on default. The hedge only works if the seller can pay. That is why credit derivatives bring their own risks.

Counterparty risk is the risk that the protection seller defaults before or when it owes payment. Your exposure is the replacement cost of the CDS, which is its positive market value to you. It is low when the reference entity is healthy and high when the reference entity is stressed. Netting and collateral reduce it.

Wrong-way risk arises when exposure to a counterparty rises as the counterparty's credit quality falls. Buying protection on a bank from another bank is a classic case. If the reference bank fails, the seller is likely hurt too, so the payout is least certain when you need it. It is worst when default of the seller and the reference entity are highly correlated, for example a seller that is heavily exposed to the same sector or country. Right-way risk is the opposite.

Basis risk is a mismatch between the hedge and the exposure. In a CDS context, the CDS-bond basis is the CDS spread minus the bond's credit spread. Hedges can also differ in maturity, currency, seniority, reference obligation or what counts as a credit event. A mismatch means the CDS payout may not match your loss.

Central clearing replaces the bilateral link with a central counterparty (CCP) through novation. The CCP collects initial and variation margin, nets positions and mutualises losses through a default fund. This lowers bilateral counterparty risk and improves transparency. But it concentrates risk in the CCP, raises liquidity demands from margin calls and can be procyclical. Lessons from the 2007-2009 crisis include opaque bilateral exposures, thinly collateralised protection sellers (AIG is the usual example), and the push to standardise and clear OTC contracts.

Key formulas to remember

CDS-bond basis
Basis = CDS spread − bond credit spread
Positive basis means CDS is more expensive than the bond spread implies. Negative basis means the reverse. Use the same maturity and the same spread benchmark.
Counterparty exposure at default
Exposure = max(V, 0)
V is the CDS market value to you. You lose only when the contract is in the money to you. With a netting agreement, use the net value across the netting set.
Expected counterparty loss (simple form)
Expected loss ≈ PD × LGD × EAD
Wrong-way risk means EAD and PD are positively linked, so using independent averages understates the loss.
Protection leg payout on default
Payout = Notional × (1 − Recovery rate)
Typical for cash or auction settlement. This is what the buyer hopes to receive from the seller.

How to solve Risks and Counterparty Issues in Credit Derivatives questions

Use this sequence for any scenario question on credit derivative risks.

  1. 1Identify who holds protection, who sold it and what the reference entity is.
  2. 2Name the risk being tested: counterparty, wrong-way, basis or clearing-related.
  3. 3Check the link between the seller and the reference entity. A strong link points to wrong-way risk.
  4. 4Check for mismatches in maturity, currency, seniority, reference obligation and credit event definition. Mismatches point to basis risk.
  5. 5Check whether netting, collateral or a CCP applies, and what residual risk remains.
  6. 6Quantify if numbers are given: exposure is max(V, 0), loss is PD × LGD × EAD, basis is CDS spread minus bond spread.
  7. 7State the effect on the hedge and the best mitigant, such as collateral with dynamic margin, diversified sellers or clearing.

Quickest way: Three-question screen

When to use it: Use for conceptual MCQs where four options sound plausible.

  1. Ask: does the exposure rise when the seller weakens? If yes, choose wrong-way risk.
  2. Ask: is the hedge different from the exposure in terms or timing? If yes, choose basis risk.
  3. Ask: is the answer about moving risk to a CCP? Then the benefit is less bilateral risk and the cost is concentration and margin liquidity strain.
  4. Eliminate options that say clearing removes all risk or that collateral removes wrong-way risk entirely.

Common mistakes in Risks and Counterparty Issues in Credit Derivatives

  • Treating wrong-way risk as just high counterparty risk

    Both involve a weak seller, so they blur together.

    Fix: Wrong-way risk needs a dependence between exposure and the seller's credit quality. Look for the link.

  • Saying central clearing eliminates counterparty risk

    Novation sounds like it removes the other party.

    Fix: It replaces bilateral risk with CCP risk. Margin and the default waterfall limit but do not remove it.

  • Getting the sign of the basis wrong

    Students reverse the subtraction.

    Fix: Basis = CDS spread − bond spread. Positive means CDS is wider than the bond.

  • Assuming a CDS hedge is perfect

    The hedge looks like a direct match to the bond.

    Fix: Check maturity, currency, seniority, reference obligation and credit event terms before calling it a full hedge.

  • Counting negative CDS value as exposure

    Exposure is confused with market value.

    Fix: Exposure is max(V, 0). If the CDS is worth less than zero to you, you owe the counterparty and have no credit exposure to it.

  • Ignoring margin liquidity cost of clearing

    Focus stays on credit risk reduction.

    Fix: Mention initial margin, variation margin calls and procyclicality as the trade-off.

Worked examples

Example 1

A bank buys USD 50 million of 5-year CDS protection on a regional bank from a dealer that is heavily exposed to that same region. The CDS has a positive value of USD 2 million to the buyer. Identify the key risk and compute exposure at default if the contract is netted with an offsetting CDS worth −USD 0.5 million to the buyer under the same netting agreement.

Show the solution
  1. The dealer's health depends on the same region as the reference bank, so exposure rises as the dealer weakens. This is wrong-way risk.
  2. Without netting, exposure = max(2, 0) = USD 2 million.
  3. With netting, net value = 2 + (−0.5) = USD 1.5 million.
  4. Exposure = max(1.5, 0) = USD 1.5 million.

Answer: The key risk is wrong-way risk. Exposure after netting is USD 1.5 million.

Exam tips

  • Look for the dependence clue. Phrases like 'same sector', 'same country' or 'bank selling protection on a bank' point to wrong-way risk.
  • For central clearing questions, give both a benefit and a cost. One-sided answers are often distractors.
  • Check that every basis calculation uses the same maturity and sign convention.
  • Expect crisis lessons to focus on opacity, undercollateralised sellers and interconnectedness.
  • Read options for absolute words such as 'eliminates' or 'always'. They are usually wrong.

Practice questions from Credit Derivatives

Risks and Counterparty Issues in Credit Derivatives: frequently asked questions

What is wrong-way risk in a CDS?

It is the risk that your exposure to the protection seller grows when the seller's credit quality falls. It typically happens when seller and reference entity are highly correlated. The hedge is then least reliable when you need it.

Does central clearing remove CDS counterparty risk?

No. It replaces bilateral exposure with exposure to a CCP, backed by margin and a default fund. It also concentrates risk and can create large liquidity demands.

What causes basis risk when hedging with CDS?

Differences between the CDS and the exposure, such as maturity, currency, seniority, reference obligation or credit event definition. The CDS-bond spread gap can also move over time.

How did credit derivatives contribute to the 2008 crisis?

Large bilateral positions were opaque and thinly collateralised, and protection sellers such as AIG faced heavy margin calls. This created interconnectedness and counterparty fears, which led to reforms such as central clearing.