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FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures

A stress-testing team observes that, in a severe market downturn, collateral received against derivative positions is concentrated in the same sovereign bonds issued by the counterparties' home country. Which risk does this most directly highlight that should be reflected in the stress test?

This highlights wrong-way risk between collateral value and counterparty creditworthiness. If the collateral is the home sovereign's debt, a downturn weakens the counterparty and cuts the collateral value at the same time, so stress tests should apply larger haircuts or dependence shocks.

  1. AWrong-way risk between collateral value and counterparty creditworthinessCorrect
  2. BBasis risk between the hedge and the underlying
  3. CSettlement risk from different time zones
  4. DModel risk from using a single volatility estimate

Explanation

When the collateral is issued by the counterparty's own sovereign, a deterioration in the country's credit lowers both the counterparty's ability to pay and the value of the collateral simultaneously. This is wrong-way risk. Stress tests should apply haircuts and correlation shocks that capture this dependence.

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