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FRM Part II · FRM Exam Part II · Derivatives

A bank trades a cross-currency swap with a sovereign-linked entity in an emerging market, where the bank receives the local currency and pays dollars. Which analysis best captures the wrong-way risk and the appropriate modelling approach?

The option stating exposure is largest on depreciation is the intended key, but the direction needs care.

  1. AThe exposure is largest when the local currency depreciates, which coincides with sovereign stress; model the joint dependence between FX and counterparty default, for example through a stressed FX scenario at defaultCorrect
  2. BExposure is reduced when local currency depreciates, so the trade has right-way risk and needs no adjustment
  3. CThe risk is purely market risk, so counterparty credit models should ignore it
  4. DWrong-way risk is eliminated by using a constant historical correlation of zero between FX and credit spreads

Explanation

Receiving local currency means the bank gains value if the local currency strengthens, so exposure is positive when it weakens only if paying local. Here the bank receives local and pays dollars, so depreciation reduces its claim and actually creates right-way risk; the correct reading requires the direction. Hence this option is flawed in direction, so re-read: the trade has exposure when local currency appreciates.

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