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FRM Part II · FRM Exam Part II · Credit Value Adjustment

A bank has an uncollateralised OTC derivative with a corporate counterparty. Which description best defines wrong-way risk in the context of credit value adjustment (CVA)?

Wrong-way risk is the situation where exposure to a counterparty tends to rise when that counterparty's probability of default rises. This positive dependence makes losses given default larger than an independence assumption suggests, so CVA is understated if the dependence is ignored.

  1. AExposure to the counterparty tends to increase when the counterparty's default probability increasesCorrect
  2. BExposure to the counterparty tends to decrease when the counterparty's default probability increases
  3. CThe recovery rate on the counterparty's debt is fixed regardless of market conditions
  4. DThe counterparty's default probability is independent of the market value of the trade

Explanation

Wrong-way risk arises when exposure and counterparty credit quality are adversely dependent: exposure rises as the counterparty becomes more likely to default. The second option describes right-way risk. The last option describes independence, which is the standard assumption that ignores wrong-way risk.

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