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FRM Part II · FRM Exam Part II · Derivatives

A bank buys a put option on its own corporate client's shares from that same client's parent holding company, which has most of its assets in the client's stock. Which description best fits the risk the bank faces on this trade?

This is specific wrong-way risk. The put is worth most when the shares fall, and the counterparty's creditworthiness depends on those shares, so exposure and default probability rise together through a direct, transaction-specific link rather than a general macroeconomic one.

  1. ASpecific wrong-way risk, because the counterparty's default probability rises when the option's exposure risesCorrect
  2. BRight-way risk, because the option gains value when the counterparty is stronger
  3. CGeneral wrong-way risk, because the link arises only through the macroeconomic cycle
  4. DNo wrong-way risk, because the put's maximum payoff is capped at the strike price

Explanation

The put gains value when the client's shares fall, and the counterparty's solvency depends on those same shares, so exposure and default probability are directly linked. This is specific wrong-way risk. The cap on payoff does not remove the dependence, and the link is legal or structural rather than only macroeconomic.

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