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FRM Part II · FRM Exam Part II · Derivatives

A bank buys credit protection on a corporate loan exposure from a protection seller whose default is positively correlated with the corporate's default (wrong-way risk). Which statement best describes the effect on the credit mitigant's value?

The protection is least reliable when needed most. Positive default correlation between seller and reference entity means the seller is likely to be stressed when the corporate defaults, so ignoring this wrong-way risk overstates the credit mitigation benefit.

  1. AThe hedge is most effective because both names default together, doubling recovery
  2. BThe protection is least reliable exactly when it is needed, so its mitigation benefit is overstated if correlation is ignoredCorrect
  3. CCorrelation has no effect provided the CDS is fully documented
  4. DThe hedge is only affected if the protection seller's rating is above the corporate's

Explanation

Positive default correlation means the seller is more likely to be distressed when the reference entity defaults, so the payout may not be received. Ignoring this overstates the mitigation. Good documentation does not remove the seller's credit risk.

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