FRM Part II · FRM Exam Part II · Credit Derivatives
A bank buys five-year credit protection on a corporate bond from a counterparty that is itself a dealer with substantial exposure to the same corporate sector. The bank's risk manager is concerned that the protection may lose value precisely when it is needed. Which risk is the manager describing?
The manager is describing wrong-way risk. The protection seller is exposed to the same sector as the reference entity, so its default becomes more likely just when the reference entity defaults and the protection is worth most, which undermines the hedge.
- ABasis risk between the bond and the reference obligation
- BWrong-way risk between the protection seller's default and the reference entity's defaultCorrect
- CLiquidity risk arising from the bid-ask spread on the CDS
- DSettlement risk from physical delivery of the bond
Explanation
Wrong-way risk arises when the probability of the counterparty's default is positively correlated with the exposure to it. Here the seller is likely to be stressed when the reference entity defaults, which is exactly when protection is valuable. Basis risk concerns mismatch between the hedge and the exposure, not correlation of defaults.
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