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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A risk manager reviews a loan secured by shares issued by the borrower's own parent company. Which concern is most directly relevant to the effectiveness of this collateral as credit risk mitigation?

The key concern is wrong-way risk: the parent's shares are likely to lose value precisely when the borrower gets into distress, so the collateral provides weak protection when it is most needed. Effective collateral should have low correlation with the borrower's default.

  1. AWrong-way risk, because collateral value is likely to fall when the borrower's credit quality deterioratesCorrect
  2. BBasis risk arising from a currency mismatch only
  3. CReduced liquidity of the loan itself in the primary market
  4. DRight-way risk, because the collateral gains value when the borrower defaults

Explanation

Collateral highly correlated with the borrower's credit standing loses value just when the bank needs it, which is wrong-way risk. Parent shares typically fall when the subsidiary borrower defaults. Right-way risk is the opposite situation, and the other options do not address the correlation problem.

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