Skip to content

FRM Part II · FRM Exam Part II · Derivatives

A bank has an uncollateralised interest rate swap with a corporate counterparty. The bank receives fixed and the counterparty is a highly leveraged firm whose credit quality deteriorates when interest rates fall. Which statement is most accurate?

The trade has wrong-way risk. Receiving fixed makes the swap valuable to the bank when rates fall, and that is exactly when this counterparty is more likely to default, so exposure and default probability move together.

  1. AThe trade exhibits right-way risk because the bank gains when rates fall
  2. BThe trade exhibits wrong-way risk because exposure rises as rates fall, when default probability also risesCorrect
  3. CThe trade exhibits no dependence because swaps have zero initial value
  4. DThe trade exhibits wrong-way risk only if the swap is paying floating

Explanation

Receiving fixed gains value when rates fall, so the bank's exposure increases in that scenario. The counterparty is also more likely to default then, so exposure and default probability are positively dependent: wrong-way risk. The zero initial value is irrelevant to future exposure.

Did you get it right without looking?

One question tells you little. A timed set on Derivatives shows your real accuracy, how long you take and where you lose marks.

Practise DerivativesFree diagnostic mock

More Derivatives questions