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FRM Exam Part II · Credit Value Adjustment

Wrong-Way and Right-Way Risk in CVA Explained

Updated 11 October 2026 · Fact-checked

Wrong-way risk (WWR) arises when exposure to a counterparty rises as its default probability rises, so CVA is higher than an independence assumption suggests. Right-way risk (RWR) is the opposite: exposure falls when default risk rises. To solve questions, identify the link between exposure and credit quality, then decide whether CVA rises or falls.

Understand Wrong-Way and Right-Way Risk

CVA is the market value of counterparty credit risk. In its simplest form it multiplies expected exposure, the probability of default and loss given default. Most simple models assume exposure and default are independent. In practice they are often linked.

Wrong-way risk exists when exposure to a counterparty is positively dependent on the counterparty's default probability. Exposure tends to be large exactly when the counterparty is most likely to default. Independent-exposure CVA then understates the true CVA.

Right-way risk exists when exposure is negatively dependent on default probability. Exposure tends to be small when default is likely. Ignoring it overstates CVA.

Specific wrong-way risk comes from a direct, legal or structural link between the counterparty and the trade. Examples: you buy a put option on the counterparty's own shares from that counterparty, or a CDS is bought from a counterparty that is closely tied to the reference entity, or a trade is collateralised with the counterparty's own securities. General wrong-way risk comes from broad macroeconomic or market factors that move both exposure and credit quality, with no direct link built into the trade. Example: the bank receives USD and pays local currency under a forward or swap with an emerging-market counterparty. If the local currency depreciates, the trade's value to the bank rises, so its exposure rises, while the counterparty's credit also worsens. The macro factor drives both.

Specific risk is often more severe and is often handled trade by trade, with default assumed to bring a jump in exposure. General risk is modelled through correlation between risk factors and credit spreads or hazard rates. Regulators also expect wrong-way risk to be identified and stress tested. They expect trades with specific wrong-way risk to be flagged and given a more conservative exposure treatment than standard models that assume independence.

Key formulas to remember

Simple CVA (independence)
CVA ≈ LGD × Σ EE(tᵢ) × PD(tᵢ₋₁, tᵢ) × DF(tᵢ)
Uses discounted expected exposure EE and marginal default probability PD, with exposure and default assumed independent.
Wrong-way effect
Positive dependence ⇒ CVA with dependence > CVA under independence
Exposure conditional on default exceeds unconditional expected exposure.
Right-way effect
Negative dependence ⇒ CVA with dependence < CVA under independence
Exposure conditional on default is below unconditional expected exposure.
Conditional exposure view
CVA ≈ LGD × Σ E[Exposure | default at tᵢ] × PD(tᵢ) × DF(tᵢ)
Replace EE by exposure given default. WWR means this is higher than EE.

How to solve Wrong-Way and Right-Way Risk questions

Use this approach for any wrong-way or right-way question, conceptual or numerical.

  1. 1Identify the trade, who owes whom, and whose default matters for CVA (the counterparty's).
  2. 2Find what drives the exposure: the underlying price, rate, FX or the counterparty's own securities.
  3. 3Ask how that driver moves when the counterparty's credit quality worsens. Same direction with higher exposure means wrong-way. Lower exposure means right-way.
  4. 4Classify as specific (direct legal or structural link) or general (macro or market factor link).
  5. 5State the effect on CVA relative to the independence-based figure: higher for wrong-way, lower for right-way.
  6. 6If numbers are given, compute CVA using exposure conditional on default where provided, otherwise use the given EE and PD.
  7. 7Name the mitigation or regulatory treatment: avoid the trade, add collateral not linked to the counterparty, use stressed exposure, or add a capital charge.

Quickest way: Two-question shortcut

When to use it: Multiple-choice items asking which situation shows wrong-way risk or how CVA changes.

  1. Ask: when the counterparty gets weaker, do I get owed more? Yes means wrong-way, no means right-way.
  2. Ask: is the link built into the trade or its collateral? Yes means specific, otherwise general.
  3. Pick the option where CVA moves in the direction of the answer: wrong-way raises it, right-way lowers it.
  4. Reject options that say wrong-way risk lowers exposure or that general risk is legally linked.

Common mistakes in Wrong-Way and Right-Way Risk

  • Treating wrong-way risk as a higher default probability alone.

    The name suggests only credit deterioration.

    Fix: Remember it is the dependence between exposure and default. Exposure must rise as default likelihood rises.

  • Mixing up specific and general wrong-way risk.

    Both involve correlation, so they feel alike.

    Fix: Specific has a direct link in the trade, such as a put on the counterparty's own stock. General comes from broad factors such as macro or sector conditions.

  • Assuming right-way risk raises CVA.

    Confusion over what is right for whom.

    Fix: Right-way is favourable to the CVA holder: exposure falls when default risk rises, so CVA falls versus independence.

  • Judging direction from the trade type alone.

    Students memorise that CDS means wrong-way.

    Fix: Check who is buying protection and who the counterparty is. Buying protection from a counterparty highly correlated with the reference entity is wrong-way, because the payout you are owed is largest when the counterparty is most likely to fail. Selling protection to such a counterparty carries little wrong-way risk for you. As the reference entity weakens, the trade's value to you falls, so you owe the counterparty and your CVA exposure to it is small, limited to unpaid premiums. The wrong-way risk sits with the protection buyer, who is exposed to the seller, not with you as the seller.

  • Believing collateral removes wrong-way risk.

    Collateral lowers exposure, so it seems to remove the issue.

    Fix: Collateral only helps if it is not correlated with the counterparty. Own-issued or highly related collateral can lose value just when needed.

Worked examples

Example 1

A bank buys a put option on a corporate's own shares from that same corporate. Classify the risk and state the effect on CVA compared with an independence-based calculation.

Show the solution
  1. The bank is owed money if the share price falls, so exposure rises as the shares fall.
  2. If the corporate's credit worsens, its share price typically falls, which raises the put's value and the bank's exposure.
  3. The link is direct, through the counterparty's own equity, so it is specific.
  4. Exposure is highest when default is most likely, so conditional exposure exceeds EE.

Answer: Specific wrong-way risk; CVA is higher than the independence-based CVA.

Example 2

Using a one-period approximation, EE is $10 million, PD is 4%, LGD is 60% and the discount factor is 0.95. Exposure given default is estimated at $16 million. Compute CVA under independence and with wrong-way dependence.

Show the solution
  1. Independence: CVA = 0.60 × 10 × 0.04 × 0.95.
  2. 0.60 × 10 = 6; 6 × 0.04 = 0.24; 0.24 × 0.95 = 0.228, so $228,000.
  3. Dependence: CVA = 0.60 × 16 × 0.04 × 0.95.
  4. 0.60 × 16 = 9.6; 9.6 × 0.04 = 0.384; 0.384 × 0.95 = 0.3648, so $364,800.
  5. Difference: 364,800 − 228,000 = $136,800, an increase of 60%.

Answer: Independence CVA is $228,000; with wrong-way dependence it is $364,800, about $136,800 higher.

Exam tips

  • Read for direction first: exposure rising with default risk means wrong-way. Many questions are solved by this alone.
  • Remember CVA is about the counterparty's default, so check which party's credit matters in each trade.
  • Expect scenario items with own-stock puts, own-issued collateral, or sovereign-linked counterparties in FX trades. Classify each as specific or general.
  • For numerical items, swap EE for exposure given default and recompute with the same PD, LGD and discount factor.
  • Watch for answer options claiming collateral always eliminates wrong-way risk. They are wrong unless the collateral is uncorrelated.

Practice questions from Credit Value Adjustment

Wrong-Way and Right-Way Risk: frequently asked questions

What is wrong-way risk in CVA?

It is the risk that your exposure to a counterparty grows when its default probability grows. This makes actual CVA higher than a calculation assuming independence between the two.

What is the difference between right-way and wrong-way risk?

In wrong-way risk, exposure and default probability move together, which increases CVA. In right-way risk, exposure falls as default probability rises, which reduces CVA.

What is the difference between specific and general wrong-way risk?

Specific wrong-way risk arises from a direct link between the trade and the counterparty, such as a put on the counterparty's own shares. General wrong-way risk arises from broad factors, such as macroeconomic or market conditions, that affect both exposure and credit quality.

Can collateral remove wrong-way risk?

Not always. Collateral reduces exposure, but if it is correlated with the counterparty's credit, such as its own bonds, its value can drop when you need it most.