FRM Part II · FRM Exam Part II · Derivatives
A bank enters a cross-currency swap with a sovereign-linked entity in an emerging market, receiving the emerging-market currency and paying USD. Which statement best describes the risk and a suitable mitigant?
This is wrong-way risk. A sovereign or currency crisis simultaneously raises the counterparty's default probability and drives the currency moves that damage the bank's position. Mitigation includes hard-currency collateral, higher haircuts or add-ons for currency mismatch, and limits on such trades.
- AIt is right-way risk because the bank benefits when the local currency strengthens
- BIt is general right-way risk and requires no mitigation since exposure falls in crises
- CIt is general wrong-way risk only if the swap is unsecured and USD-denominated
- DIt is wrong-way risk: a crisis weakens the local currency, raising the bank's loss on received payments and the counterparty's default probability together; mitigants include collateral in a hard currency and haircuts or add-ons for currency mismatchCorrect
Explanation
The bank receives local currency, so a depreciation reduces the value of its receipts; but the framing of exposure here treats the bank as owed amounts in a currency whose collapse coincides with the sovereign-linked entity's distress. The dependence between currency crisis and default creates wrong-way risk, mitigated with hard-currency collateral and conservative haircuts or add-ons.
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