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FRM Part II · FRM Exam Part II · Derivatives

Which approach best handles general wrong-way risk in the exposure measurement of a derivatives portfolio when no trade-specific link exists?

Use a stress or multiplier on exposure, or jointly simulate market risk factors and the counterparty's credit spread. This captures the dependence between market moves and credit quality that defines general wrong-way risk, whereas assuming independence understates CVA.

  1. AApply a stress or multiplier to exposure, or model dependence between market risk factors and counterparty credit spread in the simulationCorrect
  2. BAssume zero correlation because general links are statistically insignificant
  3. CRemove all netting benefits for the counterparty
  4. DUse the counterparty's historical default frequency as a flat exposure add-on

Explanation

General wrong-way risk comes from dependence between market factors and credit quality, so it is handled by joint modelling of those drivers or a calibrated multiplier on exposure, as in the regulatory alpha. Assuming zero correlation ignores it, and removing netting or flat add-ons do not capture the dependence.

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