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FRM Part II · FRM Exam Part II · Future Value and Exposure

A bank has an uncollateralised OTC derivative with a counterparty. The bank's risk team observes that the counterparty's probability of default tends to rise at the same time as the bank's exposure to that counterparty increases. Which description best fits this relationship?

This is wrong-way risk. It occurs when exposure and the counterparty's default probability are positively related, so the bank's exposure grows just when the counterparty is most likely to default. Right-way risk is the opposite, with exposure falling as default probability rises.

  1. ARight-way risk, because exposure and default probability are positively related
  2. BWrong-way risk, because exposure and default probability are positively relatedCorrect
  3. CWrong-way risk, because exposure and default probability are negatively related
  4. DRight-way risk, because exposure and default probability are negatively related

Explanation

Wrong-way risk arises when exposure to a counterparty is adversely correlated with its credit quality, meaning exposure rises as default probability rises. Right-way risk is the reverse, where exposure falls as default probability rises. The options pairing 'right-way' with positive dependence, or 'wrong-way' with negative dependence, misdefine the sign of the relationship.

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