FRM Part II · FRM Exam Part II · Derivatives
A risk manager holds a corporate bond and has bought CDS protection on the same issuer from a dealer bank that is highly correlated with the issuer's sector. Which risk is most directly introduced by this hedge?
The hedge introduces wrong-way risk. The protection seller is correlated with the reference entity's sector, so its ability to pay is weakest exactly when the issuer defaults and the CDS payout is needed, making the counterparty exposure and default likelihood move together.
- AWrong-way risk in the counterparty exposureCorrect
- BBasis risk eliminated entirely by matching maturities
- CInterest rate risk on the CDS premium leg
- DPrepayment risk on the bond
Explanation
If the protection seller is correlated with the reference entity, its default likelihood rises when the CDS becomes most valuable, creating wrong-way risk. Matching maturities does not remove all basis risk, and the other options are not the main risk introduced by this hedge.
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