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FRM Part II · FRM Exam Part II · Credit Derivatives

A bank buys five-year credit default swap protection on a corporate bond it holds, referencing the bond issuer. The protection seller is a large insurance company whose own credit quality is strongly positively correlated with the reference entity's, since both are concentrated in the same sector. Which risk is the bank most exposed to as a result of this correlation?

The bank faces wrong-way risk. Because the protection seller's credit quality moves with the reference entity's, the seller is most likely to be distressed when the reference entity defaults, which is when the payout is needed, so the hedge's value is undermined.

  1. AWrong-way risk, because the seller is most likely to be unable to pay exactly when the reference entity defaultsCorrect
  2. BBasis risk, because the CDS spread will differ from the bond's asset swap spread
  3. CLiquidity risk, because the CDS cannot be unwound before maturity
  4. DInterest rate risk, because the protection premium is paid periodically

Explanation

Positive dependence between the protection seller's default and the reference entity's default means the hedge is likely to fail just when it is needed. This is wrong-way counterparty risk. Basis risk concerns pricing differences between instruments and does not arise from the seller-reference correlation.

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