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

A bank buys credit protection on a corporate borrower from a counterparty whose default is highly likely to occur at the same time as the borrower's default, because both are exposed to the same sector downturn. What is the main weakness of this hedge?

The main weakness is wrong-way risk. Because the protection seller is likely to default at the same time as the borrower, the hedge may fail to pay when the credit event occurs, undermining the protection the bank bought precisely when it is most needed.

  1. AWrong-way risk, which reduces the hedge value when it is needed mostCorrect
  2. BBasis risk arising from a maturity mismatch only
  3. CLiquidity risk because CDS cannot be traded
  4. DPrepayment risk on the underlying loan

Explanation

When protection seller default correlates with reference entity default, the seller may be unable to pay exactly when the claim arises. This is wrong-way (correlation) counterparty risk. Maturity mismatch is a separate issue and no such mismatch is described. Prepayment risk is unrelated.

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