FRM Part II · FRM Exam Part II · Derivatives
A bank is assessing wrong-way risk in its CVA on a derivative portfolio. Which situation represents specific wrong-way risk?
Buying a put option on a company's own shares from that company is specific wrong-way risk, because the option's value and exposure rise as the share price falls, which is precisely when the counterparty's default probability increases. Netting and daily margining are mitigants rather than wrong-way risk.
- AThe bank buys a put option on a company's own shares from that same companyCorrect
- BThe bank enters an interest rate swap with a highly rated bank
- CThe bank enters a netting agreement covering all trades with a counterparty
- DThe bank receives daily variation margin in cash on a swap
Explanation
Specific wrong-way risk arises when exposure to a counterparty is directly linked to its default probability. A put on the counterparty's own shares gains value exactly when its share price falls, which is when default risk rises. The other choices describe a normal credit relationship or risk mitigants, not a link between exposure and default.
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