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FRM Part II · FRM Exam Part II · Credit Value Adjustment

A bank buys a put option on its own corporate counterparty's shares from that same counterparty (the counterparty is the writer of the put). Which statement best describes the risk to the bank?

This is specific wrong-way risk. The bank holds a put written by the counterparty on the counterparty's own shares, so the put becomes more valuable, and the bank's exposure larger, precisely when the share price falls and the writer is closer to default.

  1. ASpecific wrong-way risk, because the put gains value as the counterparty's share price falls and default becomes more likelyCorrect
  2. BRight-way risk, because the put loses value when the counterparty's credit quality deteriorates
  3. CGeneral wrong-way risk only, because the link arises from macroeconomic factors rather than the counterparty's own shares
  4. DNo wrong-way risk, because the bank is long an option and pays a premium upfront so credit exposure is zero

Explanation

The put's value rises when the underlying share price falls, which is exactly when the writer is more likely to default, and the bank has positive exposure since it is long the option. This direct, transaction-specific link is specific wrong-way risk. The premium paid upfront does not remove the future exposure if the put moves into the money.

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