LO 31.2: Identify examples o f wrong-way risk and examples o f right-way risk.

LO 31.2: Identify examples o f wrong-way risk and examples o f right-way risk.
For this LO, well create a few hypothetical examples of WWR and RWR. For example, what if Company XYZ (the borrower) and the guarantor on XYZs loan, Company ABC, share ownership in a business (or are in the same industry)? Due to some market or economic factors, both may default together (WWR), whereas if the guarantor and the borrower are not in the same industry (nor have shared ownership), XYZs loan guarantee may still be valid, even if XYZ defaults (RWR).
What if ABC has sold protection much higher than its capital in a concentrated area (business or industry) and XYZ has bought protection (insurance) from ABC? Macro factors may increase the exposure for the guarantor (ABC), and due to positive interaction between exposure and credit quality, the overall counterparty (guarantor) risk increases to
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the extent that XYZs protection becomes meaningless (WWR). In contrast, the reverse of the situation may generate a favorable state an increase in exposure may be sufficiently offset by an increase in creditworthiness.
The CVA, which is based on the amount of counterparty risk, is generally approximated by the product of exposure and the default probability of the counterparty (for a given recovery rate). This estimation is based on an underlying assumption that these events are independent. However, they may not be independent (as evidenced in the recent financial crisis). Unfavorable (favorable) association between default probability (credit risk) and exposure (market risk) may produce WWR (RWR), increasing (decreasing) the overall CVA.
Quantifying WWR and RWR involves estimation of the CVA based on expected exposure, conditional on counterparty default (under the more realistic scenario of the presence of interconnected markets with systemic risk), whereas under the independence assumption, we use unconditional default probability.
It is estimated that conditional expected exposure will increase if the exposure (e.g., value of a forward contract) and the default probability of the counterparty are positively correlated, exhibiting WWR. On the other hand, negative correlation in this instance will lower the conditional expected exposure, showing RWR.
As discussed earlier, the overall counterparty risk stems from a situation in which the counterparty credit quality is linked with macro (and global) factors that also impact the exposure of transactions. The transaction can be any of the following: put options, call options, foreign currency transactions, forward contracts, credit default swaps, or interest rate and currency swaps. Let us examine WWR and RWR as they relate to some of these transactions.
Over-the-Counter Put O ption
A put option gives the right to the long (buyer) to sell an underlying instrument at a predetermined price whereas the short (counterparty) is obligated to buy if the option is exercised. Out-of-the money put options have more WWR than in-the-money put options.
Macroeconomic events (such as interest rates, inflation, industry- and sector-specific factors, or global factors) may deteriorate the creditworthiness of the counterparty, increasing the default probability. The same factors may trigger a fall in the underlying (e.g., stock) assets price, generating positive payoffs for the long but increasing the counterparty risk exposure. Before the long gets too excited to see an increase in payoffs, he is hit by the realization of increasingly becoming a victim of WWR, due to positive correlation between the risk exposure of the counterparty and probability of default of the counterparty producing an overall increase in counterparty risk. The payoffs may not materialize, although they are increasing. On the other hand, normalcy of the transaction would be termed as RWR if the counterparty is able to fulfill its obligation despite an increase in its position obligation.
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Professors Note: We are assuming in the previous put option example that the counterparty and the underlying issuer are the same in order to clearly illustrate WWR. The positive association between default probability and exposure will still give rise to WWR i f the counterparty and underlying issuer are not the same.
Over-the-Counter Call O ption
A call option gives the right to the long (buyer) to buy an underlying instrument at a predetermined price whereas the short (counterparty) is obligated to sell at the agreed-upon price if the option is exercised. Like the put option, we are assuming the counterparty and the underlying issuer are the same.
Assume that due to changes in some macroeconomic and global factors, the default probability of the counterparty declines, and the price of the underlying asset (e.g., stock) increases, producing higher payoffs for the call buyer. In this instance, his excitement of making money will be appropriate because the counterparty will be in a strong position to pay off its obligation (due to the overall increase in creditworthiness). Such an outcome will be considered the normalcy of the transaction, and it is termed RWR. The short is able to fulfill its obligation despite the increase in its position obligation. On the other hand, if the counterparty is unable to fulfill its obligation due to the increase in its position obligation (higher value of underlying for the long, but higher obligation for the short an increase in counterparty risk exposure), it would be an example of WWR (from the standpoint of the long position).
Credit D efault Swaps (C D Ss)
The 20072009 credit crisis offers a classic example of WWR from the perspective of the longs (i.e., the buyers) who had bought protection on issuers default on collateralized debt obligations (CDOs) or bonds backed by mortgage-backed securities (MBSs) via credit default swaps (CDSs).
As the real estate bubble burst and the market started taking a downward freefall, the value of MBSs started exhibiting a freefall as well. The monoline insurers, such as AMBAC and MBIA, had taken highly concentrated positions in offering protection against MBSs and CDOs. As the issuers of MBSs and CDOs started defaulting, the insurers were flooded by claims from the ones who had bought the protection (i.e., holders of CDSs).
The value of CDSs was rising, but this gain was generating an increase in risk exposure to the counterparty. Both the probability of default and the risk exposure of the insurers were rising. The unfortunate buyers of protection soon found out that the macrocredit and exposure linkage had produced unfavorable results for them. Despite huge gains on their positions, nothing materialized due to the deteriorating creditworthiness of the issuers, an example of WWR.
The normalcy of the transaction would be if the counterparty could fulfill its obligation despite an increase in position exposure (perhaps due to a negative association between risk exposure and probability of default). This would be an example of RWR. If insurance
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company ABC, for example, had taken a nonconcentrated exposure, it might not have experienced a decline in its creditworthiness (due to fewer claims) and would have been able to satisfy its obligations despite increasing risk exposure in the CDSs.
Foreign Currency Transactions
Consider a commercial bank in a developed economy (e.g., the United States) that enters into a cross currency agreement with a commercial bank (counterparty) in an emerging market (e.g., Uzbekistan), under which the counterparty will deliver developed market currency in return for local currency.
Macro conditions in the emerging country, such as a sovereign debt crisis, generate credit stress for the local bank, as well as a decline (depreciation) of local currency. The value of the transaction increases substantially for the financial institution in the developed economy due to the declining currency of the emerging economy. At the same time, the counterparty risk exposure increases as the gain for the financial institution in the developed economy increases.
Increases in default probability (due to credit stress) and risk exposure (due to declining currency) increase counterparty risk, resulting in WWR for the financial institution in the developed economy.
If the counterparty risk exposure and the credit quality are not unfavorably associated, then the risk exposure may increase, but the probability of default may decline (due to improvement in creditworthiness), producing a reduction in overall counterparty risk. This would be an example of RWR.
Foreign Currency Swaps
A real-world example will further clarify WWR in the foreign currency swaps market. Prior to the recent credit crisis in the United States, numerous financial institutions in Japan had entered into swap agreements with U.S. financial institutions to obtain dollar funding by using yen. They pledged yen to get U.S. dollars. After the default of Lehman Brothers, the financial crisis reached its peak, raising grave concerns about the economic slowdown of the U.S. and European economies. The yen significantly appreciated against the U.S. dollar, resulting in a substantial gain to Japanese bank positions (the pledged yen will buy more dollars, and U.S. banks will have to surrender more dollars for the pledged yen), increasing the counterparty risk exposure for Japanese banks. At the same time, deteriorating macro conditions had a negative impact on U.S. banks and the economy. In addition, the default probabilities of the U.S. financial institutions increased. Positive (unfavorable) association between counterparty risk exposure and default probability generated an overall increase in counterparty risk for Japanese banks, and they experienced WWR.
If the risk exposure and default probabilities are not positively associated, the normalcy of the transaction would balance out the increase in risk exposure by improving the creditworthiness of the financial institutions (macro factors may be related to both events in a different manner), lowering overall counterparty risk. The counterparty is able to meet its obligation despite an increase in risk exposure (due to an appreciating yen). This would be an example of RWR.
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Interest Rate Transactions
Interest rate swaps provide another good illustration of WWR. In an interest rate swap, one party (i.e., the long or fixed-rate receiver) enters into an agreement with a counterparty (i.e., the fixed-rate payer) to receive a fixed rate and pay a floating rate. The fixed-rate receiver gains if the market interest rate (the swap rate) falls.
Assume due to macroeconomic conditions (e.g., an economic downturn), policy interest rates are lowered. The fixed-rate receiver experiences a value gain to the extent that the swap rate declines against the counterparty with the fixed-rate payer and floating-rate receiver. However, this gain for the fixed-rate receiver also produces an increase in its counterparty risk exposure. Furthermore, if the economic downturn would also increase the default probability, then overall counterparty risk will increase, generating WWR for the fixed-rate receiver.
This is exactly what happened during the recent European sovereign debt crisis. Due to lower inflation and an economic recession, the policy interest rates were lowered. The euro (interest rate) swap rate declined, producing a gain for those who were holding fixed interest rate receiver positions against Italian financial institutions (fixed-rate payer). However, the decline in the euro swap rate also increased the counterparty risk exposure. Deteriorating economic conditions also increased the default probability of Italian financial institutions. An increase in both the risk exposure and default probability resulted in an overall increase in counterparty risk, generating WWR for the holder of fixed-rate receiver swaps.
In the absence of a positive association between risk exposure and default probability, the Italian financial institutions might have been able to fulfill their obligations comfortably, despite the increase in exposure, generating RWR.
Com m odities
Airlines hedge against the risk of rising oil prices. For example, assume an airline is long an oil forward contract at a fixed price. The counterparty is a dealer who has taken heavy concentrated positions. If oil prices rise, the gains for the airline will rise. The airline will buy cheap oil because the spot price will be higher than the locked-in forward price, but at the same time, the risk exposure for the dealer will increase. Because the dealer had concentrated positions, there may be a flood of claims (several forward contract claims brought by various airlines), putting intense pressure on the credit quality of the counterparty. Thus, an increase in both the risk exposure and the default probability will increase overall counterparty risk, producing WWR.
On the other hand, a dealer with a nonconcentrated position may continue to have sound creditworthiness despite rising exposure. Thus, the dealer will be able to fulfill her obligation, lowering the overall expected amount of risk exposure from the standpoint of the airline. This would be an example of RWR.
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T h e Im p a c t o f W W R o n C o l l a t e r a l a n d C C P s

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