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

A bank's risk manager reviews a portfolio of uncollateralised derivatives with a corporate client. She notes that the counterparty's probability of default tends to rise at the same time as the bank's exposure to it rises. Which term best describes this relationship?

This is wrong-way risk. It occurs when a bank's exposure to a counterparty increases at the same time as the counterparty's default probability increases, so losses given default are larger than independence between the two would imply.

  1. AWrong-way riskCorrect
  2. BRight-way risk
  3. CSettlement risk
  4. DBasis risk

Explanation

Wrong-way risk arises when exposure to a counterparty is adversely correlated with the counterparty's credit quality, so exposure is high when default is more likely. Right-way risk is the opposite relationship. Settlement and basis risk describe different exposures and do not capture the link between exposure and default.

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