FRM Part II · FRM Exam Part II · Credit Risk Management
A bank buys protection via a CDS from a dealer that is highly correlated with the reference entity, for example a bank whose fortunes depend on the same sovereign that is the reference entity. Which statement best describes the risk the buyer faces?
The buyer faces wrong-way risk. Because the seller's creditworthiness deteriorates together with the reference entity, the protection is most likely to be owed when the seller is weakest, so the hedge is worth less than its notional suggests and should be reflected in counterparty credit adjustments.
- AWrong-way risk: the protection is most likely to be needed when the seller is least able to pay, so the hedge's effectiveness is lower than the contract suggestsCorrect
- BRight-way risk: the seller becomes stronger as the reference entity deteriorates, so the hedge is more reliable
- CBasis risk only, which arises because the CDS spread differs from the bond spread
- DModel risk only, arising because recovery rates are fixed by the contract
Explanation
When the protection seller's default probability rises with that of the reference entity, the counterparty is likely to fail exactly when payout is due. This is wrong-way risk and it reduces the hedge's value and should be reflected in the CVA. Basis risk concerns spread differences, not seller-reference correlation.
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