FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures
A risk manager designs a stress scenario for a portfolio of cleared and bilateral derivatives. Which feature of the scenario would best capture wrong-way risk in the collateral that the bank holds from a bank counterparty?
The best feature is a joint shock where the sovereign bonds posted as collateral fall sharply at the same time as the counterparty deteriorates. This reflects wrong-way risk, because the collateral loses value precisely when the bank needs it, so stressed collateral cover is much weaker than assumed.
- AAssuming the counterparty posts only cash in its home currency, with no haircut
- BApplying a severe fall in the value of the sovereign bonds that the counterparty posts, coinciding with the counterparty's own deteriorationCorrect
- CReducing all volatilities to calm-market levels
- DAssuming collateral is always rehypothecated by the bank
Explanation
Wrong-way risk arises when collateral value is positively correlated with the counterparty's default, for example a bank posting its own sovereign's bonds. A joint shock to the collateral value and the counterparty's credit quality captures this. Calm volatilities and unhaircut cash understate the risk.
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