FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk
A bank wants to reduce credit risk on a corporate loan by buying protection. Which feature of a collateral arrangement most directly introduces wrong-way risk for the bank?
Collateral consisting of shares issued by the borrower creates wrong-way risk. If the borrower's credit deteriorates, the share price falls, so the collateral loses value exactly when the bank needs it. Cash, daily margining and independent custody all strengthen, not weaken, the protection.
- AThe collateral is cash in the same currency as the exposure
- BThe collateral consists of shares issued by the borrower itselfCorrect
- CThe collateral is subject to daily margin calls
- DThe collateral is held by an independent custodian
Explanation
Wrong-way risk arises when collateral value falls as borrower credit quality worsens. Borrower-issued shares lose value just when default risk rises, so protection disappears when needed. The other features reduce risk.
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