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FRM Part II · FRM Exam Part II · Portfolio Credit Risk

A portfolio manager buys CDS protection on a corporate borrower from a dealer that is highly correlated with that borrower's sector (for example, a bank heavily exposed to the same industry). Which risk is most clearly increased by this hedge?

Wrong-way risk is the main concern. When the protection seller's credit quality is positively correlated with the reference borrower, the seller is more likely to be unable to pay just when the borrower defaults, so the hedge's value falls when it is most needed.

  1. AWrong-way risk between the protection seller and the reference entityCorrect
  2. BBasis risk from differing maturity of the CDS
  3. CInterest rate risk on the loan
  4. DPrepayment risk on the loan

Explanation

If the seller's creditworthiness deteriorates when the reference entity defaults, the protection is least reliable exactly when needed. This is wrong-way risk arising from default correlation between seller and reference entity. Maturity mismatch is a separate issue not described.

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