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FRM Part II · FRM Exam Part II · Derivatives

A bank has a put option on its counterparty's own shares, bought from that counterparty. Compared with a put on an unrelated stock bought from the same counterparty, which statement is most accurate?

The put on the counterparty's own shares creates specific wrong-way risk. It is most valuable to the bank when the counterparty's share price drops, which coincides with higher default probability, so exposure and default likelihood rise together, unlike a put on an unrelated stock.

  1. AExposure is lower because the put loses value as the counterparty's share price falls
  2. BThe risk is identical, since option payoffs do not depend on the issuer's credit quality
  3. CThe risk is right-way, because the put is in the money when the counterparty is healthy
  4. DThe put's exposure is highest when the counterparty's share price has fallen, which is when its default probability is high, creating specific wrong-way riskCorrect

Explanation

A put gains value as the underlying share falls. When the counterparty's own shares fall, its credit quality is deteriorating and default is more likely, so exposure peaks as default risk peaks. This is specific wrong-way risk; an unrelated stock lacks that link.

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