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

A bank buys a put option on its own shares... Consider instead: a bank buys a put option on a stock from a counterparty that is a highly leveraged issuer of that same stock. How is this best characterised?

This is specific wrong-way risk. When the issuer deteriorates, its shares fall and the put the bank holds becomes more valuable, raising exposure exactly when the counterparty is most likely to default. The link is direct and name-specific, not a broad macro relationship.

  1. ASpecific wrong-way risk, because the put gains value as the issuer's credit quality deterioratesCorrect
  2. BRight-way risk, because the put loses value as the issuer weakens
  3. CGeneral wrong-way risk arising from interest rate movements only
  4. DNo dependence, because options have bounded exposure

Explanation

If the issuer's condition worsens, its share price falls, so the put the bank holds gains value just as the counterparty is more likely to default. This direct, name-specific link is specific wrong-way risk. It is not right-way risk, and option exposure being bounded does not remove the dependence.

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