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

A bank has bought protection through a credit default swap from a counterparty that is a large insurer heavily exposed to the same reference sector. The insurer posts its own equity-linked notes as collateral. Which risk is most directly illustrated, and what is the key concern?

This is wrong-way risk. The exposure on the protection rises just when the insurer is most likely to default, and collateral linked to the insurer itself loses value at the same time. That co-movement makes collateral less reliable than standard exposure models assume.

  1. AWrong-way risk: the counterparty's default probability and the exposure and collateral weakness tend to rise togetherCorrect
  2. BRight-way risk: exposure falls as counterparty credit quality worsens
  3. CSettlement risk: the payment leg may fail on a single day
  4. DBasis risk: the CDS and bond prices may diverge slightly

Explanation

When the reference sector deteriorates, CDS value (the bank's exposure) rises while the insurer's creditworthiness and its self-issued collateral value fall. This positive dependence between exposure and default probability is wrong-way risk. Right-way risk is the opposite relationship.

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