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FRM Part II · FRM Exam Part II · Margin (Collateral) and Settlement

A bank has a swap with a counterparty whose posted collateral consists mainly of bonds issued by the counterparty's own parent company. Which risk is most directly created, and why?

This creates specific wrong-way risk. Bonds of the counterparty's parent are likely to fall in value precisely when the counterparty is nearing default, so the collateral shrinks when it is most needed, undermining the protection it is supposed to provide.

  1. ARight-way risk, because the collateral value rises when the counterparty's credit quality improves
  2. BBasis risk, because the collateral and exposure are in different currencies
  3. CSpecific wrong-way risk, because the collateral's value is likely to fall just when the counterparty is more likely to defaultCorrect
  4. DSettlement risk, because collateral transfers occur at different times

Explanation

Collateral issued by the counterparty or a closely related entity loses value as the counterparty's credit deteriorates, so it is least valuable when needed. This is wrong-way risk tied to a specific relationship. Right-way risk is the opposite direction, and the other options do not describe the main problem.

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