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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank buys CDS protection on a corporate bond it owns. The protection seller is a dealer whose default is highly positively correlated with the reference entity's default (wrong-way risk). Which conclusion is most accurate regarding the hedge's effectiveness?

The hedge is least reliable when it is needed most. With high positive default correlation, the protection seller is likely to be distressed when the reference entity defaults, so payment may not be made. This wrong-way risk reduces the value of the protection.

  1. AThe hedge is least reliable in precisely the states where a payout is needed, because seller failure becomes likelier when the reference entity defaultsCorrect
  2. BThe hedge is more reliable, because correlated defaults cancel each other out
  3. CCorrelation has no effect since the CDS is collateralized by the reference bond itself
  4. DThe hedge is unaffected because payout size depends only on the spread paid

Explanation

With wrong-way risk, the seller is more likely to be distressed when the reference entity defaults, which is when payment is due. This lowers the hedge's value. Correlated defaults do not offset; they compound the loss, and the CDS is not secured by the bond.

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