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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 same client, to hedge a stock holding. Which statement best characterises the credit exposure on this trade?

It is specific wrong-way risk. The put pays off most when the issuer's share price falls, which is also when the issuer is most likely to default, so the bank's exposure peaks just as the counterparty's ability to pay is weakest.

  1. AIt is specific wrong-way risk, because the put is worth most when the client's share price falls and default is more likelyCorrect
  2. BIt is right-way risk, because a fall in the share price reduces the client's ability to pay
  3. CIt is general wrong-way risk only, driven by interest rate levels
  4. DIt carries no wrong-way risk because the option premium was paid upfront

Explanation

The put gains value as the client's own shares fall, which is when the client's credit quality deteriorates. The link is direct and transaction-specific, so it is specific wrong-way risk. Paying the premium upfront does not remove the bank's later exposure to the payoff.

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