LO 31.1: Describe wrong-way risk and contrast it with right-way risk.

LO 31.1: Describe wrong-way risk and contrast it with right-way risk.
Wrong-way risk (WWR) is an outcome of any association, dependence, linkage, or interrelationship between exposure and counterparty creditworthiness that generates an overall increase in counterparty risk and, therefore, an increase in the amount of the credit value adjustment (CVA). WWR also results in a reduction of the debt value adjustment (DVA). WWR can be hard to determine due to difficulties assessing the relationship among variables and the lack of relevant historical data.
Right-way risk (RWR) is just the opposite of WWR. That is, any dependence, linkage, or interrelationship between the exposure and default probability of a counterparty producing an overall decrease in counterparty risk is described as RWR. RWR decreases the CVA and increases the DVA.
It is also worth mentioning that WWR has been the center of attention in historical context, while RWR has been paid relatively little attention. However, both risks are important, and financial institutions should strive to increase RWR and decrease WWR.
.Another way to contrast WWR and RWR is to think that normality in derivatives markets is an example of RWR. That is, derivatives transactions produce intended results if the market is functioning in an expected manner. For instance, a coffee producer would sell (i.e., short) forward or futures contracts in order to protect against the downside risk of falling prices in the future, and a textile owner (that manufactures cotton cloth) would go
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Topic 31 Cross Reference to GARP Assigned Reading – Gregory, Chapter 17
long in cotton derivatives contracts if she anticipates a rise in cotton prices. Thus, RWR produces a favorable relation between default probability and exposure, reducing overall counterparty risk. Hedges, in normal functioning markets, should automatically generate RWR because the fundamental purpose of hedges is to curtail counterparty risk.
Professors Note: We are using derivatives markets ju st for illustration of wrong-way and right-way risks. By no means are these risks confined only to derivatives.
Markets and numerous interactions (e.g., market credit interaction) do not always produce normal behavior, as evidenced by the recent global financial crisis. Those who were seeking protection against the default of debt issuers (e.g., on collateralized debt obligations) became victims of WWR when unfavorable interaction between exposures and insurers default probabilities (which were supposed to provide protection) intensified the amount of counterparty credit risk.
The amount of counterparty risk is roughly equal to the product of exposure and the counterpartys default probability at a specified loss rate given default. Counterparty risk is a kind of credit risk that is estimated as loss reserve for loans, and in over-the-counter (OTC) derivatives markets, it is similar to estimating loan reserves.
Loan exposure, however, is normally assumed to be a fixed amount for a specified time period, whereas in OTC derivatives, the exposure fluctuates depending on market conditions. An example of WWR (RWR) would be a change in exposure and counterparty credit quality, producing an unfavorable (favorable) dependence in exposure and counterparty credit quality and resulting in an increase (decrease) in the amount of overall counterparty risk. The change in exposure and credit quality could be due to numerous external factors such as interest rates, inflation, exchange rate movements, and global events. Note that credit quality increases actually increase WWR. This is because counterparties with high credit quality are less likely to default. As a result, the occurrence of a default by a counterparty with high credit quality is less expected than a default by a counterparty with low credit quality.
E x a m p l e s o f W r o n g -W a y R i s k a n d R i g h t -W a y R i s k

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