Skip to content

FRM Part II · FRM Exam Part II · Future Value and Exposure

A bank buys a put option on its own corporate client's shares from that client, which is a highly leveraged firm. Which statement best describes the nature of the risk and why?

This is specific wrong-way risk. The put gains value when the client's share price drops, which is exactly when the client is more likely to default and be unable to pay, so exposure and default probability are directly and adversely linked through the same underlying.

  1. ASpecific wrong-way risk, because the option is more valuable precisely when the client's share price falls and its default likelihood risesCorrect
  2. BRight-way risk, because the option gains value when the client's share price falls and so the bank is protected
  3. CGeneral wrong-way risk, because interest rate movements affect all counterparties equally
  4. DNo wrong-way risk, because options always have non-negative exposure for the buyer

Explanation

The put pays off when the client's shares fall, which is when the client's credit quality deteriorates, so exposure and default are directly linked through the same underlying. That is specific wrong-way risk. Option 2 ignores that the payer is the weak counterparty; option 4 confuses non-negative exposure with independence from default.

Did you get it right without looking?

One question tells you little. A timed set on Future Value and Exposure shows your real accuracy, how long you take and where you lose marks.

Practise Future Value and ExposureFree diagnostic mock

More Future Value and Exposure questions