LO 31.3: Discuss the im pact o f wrong-way risk on collateral and central

LO 31.3: Discuss the im pact o f wrong-way risk on collateral and central counterparties.
Collateral can be viewed as a way to reduce exposure. Therefore, when exposure is increasing significantly, its important to evaluate the overall impact of collateral on WWR. In cases where exposure is gradually increasing (before default), collateral is typically taken to minimize the impact of WWR. In this scenario, the benefit from collateral will increase as WWR increases, because additional collateral is relatively easy to request and receive. However, in cases where exposure jumps at a certain point in time, the benefits of collateral will be very limited. For example, with a jump in exposure, such as a currency devaluation associated with a sovereign default, it is much more difficult to receive collateral in a timely fashion.
Central counterparties (CCPs) are particularly susceptible to WWR given their dependence on collateral and default fund contributions. Recall from Topic 28 that the CCP relies on a defaulting members posted margin (i.e., collateral) and default fund contribution to absorb potential losses. If these amounts do not cover losses, the CCP will need to use their own equity capital and/or default funds from non-defaulting members to help remain solvent.
However, the CCPs loss waterfall structure may be insufficient if member initial margins and default fund contributions fail to incorporate WWR. Since WWR tends to increase with increasing levels of credit quality, it could be argued that CCPs should demand higher levels of margin and default fund contributions from those members with higher credit quality. In addition, the collateral accepted by the CCP may also carry WWR. Some members may choose to post risky and illiquid assets as collateral, which may create higher levels of WWR for the CCP. One way to mitigate this practice is for the CCP to impose higher haircuts on specific assets that are accepted as collateral.
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Topic 31 Cross Reference to GARP Assigned Reading – Gregory, Chapter 17
K e y C o n c e p t s
LO 31.1
Financial institutions should pay more attention to wrong-way risk and right-way risk for planning purposes. The recent global financial crisis and European sovereign debt crisis have illustrated the significance of these risks.
Numerous macroeconomic events can impact exposure risk and default probability, producing an overall increase in counterparty credit risk. Position gains may not materialize due to an increase in the counterpartys overall risk. This is an example of wrong-way risk.
On the other hand, favorable associations between exposure risk and default probability resulting from changes in macro factors may produce a decline in overall counterparty credit risk. This is an example of right-way risk.
L 0 31.2
Wrong-way risk and right-way risk can be identified in numerous investment products and transactions, such as call options, put options, credit default swaps, foreign currency transactions, interest rate products, currency swaps, and forward contracts.
The key to identify wrong-way and right-way risk is to assess the impact on overall counterparty risk. If the co-movement between risk exposure and default probability generates an overall increase (decrease) in counterparty risk, it would be an example of wrong-way risk (right-way risk).
During the recent global financial crisis, credit default swaps offered a classic example of wrong-way risk. The buyers of credit default swaps (protection against the default of bond issuers) experienced a substantial gain as the values of the bonds backed by mortgage- backed securities started tumbling. However, the collapse of the mortgage market not only increased the risk exposure but also the default probability, leading to an overall increase in counterparty risk. There were many buyers of credit default swaps whose gains remained paper gains due to the deteriorating creditworthiness of the counterparty.
LO 31.3
When exposure is increasing gradually, the impact of collateral on WWR will be beneficial. As WWR increases, more collateral can be taken. However, when there is a jump in exposure, the impact of collateral on WWR will be limited due to the inability to receive collateral in a timely fashion.
Central counterparties (CCPs) may be impacted by WWR if they fail to incorporate this risk into their members initial margins and default fund contributions. To mitigate the impact of WWR, CCPs should require higher margin (i.e., collateral) and default funds from members with better credit quality. CCPs should also impose higher haircuts on any posted collateral that may increase WWR.
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Topic 31 Cross Reference to GARP Assigned Reading – Gregory, Chapter 17
C o n c e p t C h e c k e r s
1.
How many of the following statements regarding wrong-way risk (WWR) and right- way risk (RWR) are correct? I. Co-movement in risk exposure and default probability producing a decline in
overall risk is an example of wrong-way risk.
II. Co-movement in risk exposure and default probability producing an increase in
overall counterparty risk is an example of right-way risk.
III. Co-movement in risk exposure and default probability producing neither a
decline nor an increase in the overall counterparty risk is an example of wrong- way risk.
IV. Co-movement in risk exposure and default probability producing a decline in risk exposure but an increase in counterparty default probability is an example of right-way risk.
A. None. B. All. C. Two. D. Three.
2.
Which of the following events would likely lead to an increase in WWR? I. The borrower and the guarantor are business partners. II. A monoline insurer sold protection concentrated in a business or industry. A. I only. B. II only. C. Both I and II. D. Neither I nor II.
3.
Which of the following statements regarding WWR and RWR is correct? A. A long put option is subject to WWR if both risk exposure and counterparty
default probability decrease.
B. A long call option experiences RWR if the interaction between risk exposure
and counterparty default probability produces an overall decline in counterparty risk.
C. Declining local currency can decrease the position gain in a foreign currency
transaction, while increasing risk exposure of the counterparty.
D. The 20072009 credit crisis provides an example of WWR from the perspective
of a long who had sold credit default swaps (CDSs) as protection against bond issuers default.
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Topic 31 Cross Reference to GARP Assigned Reading – Gregory, Chapter 17
4.
How many of the following statements regarding counterparty risk are correct? I.
Speculation in normal-functioning derivatives markets automatically produces RWR.
II. RWR has been the center of attention in historical context, whereas WWR has
not been paid much relative attention.
III. The counterparty default probability does not enter into the equation for
estimating the overall counterparty risk.
IV. Unlike exposure to OTC derivatives, which is normally assumed to be a fixed
amount for a specified time period, exposure to bank loans fluctuates depending on market conditions.
A. None. B. All. C. Two. D. Three.
3.
Which of the following statements is correct? I. Depreciation of the yen after the default of Lehman Brothers gave a substantial gain to Japanese bank foreign currency swaps positions to obtain dollar funding in interest rate swaps.
II. Fixed-rate receivers experience a value gain to the extent that the swap rate
increases.
A. I only. B. II only. C. Both I and II. D. Neither I nor II.
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Topic 31 Cross Reference to GARP Assigned Reading – Gregory, Chapter 17
C o n c e p t C h e c k e r An s w e r s
1. A A decline in overall counterparty risk is an example of right-way risk. An increase in overall
counterparty risk is an example of wrong-way risk. An increase in overall counterparty risk is a condition for the emergence of wrong-way risk. A decline in risk exposure but increase in counterparty default probability may or may not lower overall counterparty risk.
2. C WWR will increase if the borrower and guarantor are business partners. The guarantees offered by a monoline insurer may turn out to be worthless if the risk exposure increases and the guarantor is hit by a flood of claims due to a concentrated position in an industry or business.
3. B A long call option experiences RWR if risk exposure and counterparty default probability results in decreased counterparty risk. A long put option is subject to WWR if both risk exposure and counterparty default probability increase. Declining local currency can increase the position gain in a foreign currency transaction, while increasing counterparty risk exposure. The 2007-2009 credit crisis provides an example of WWR from the perspective of a long who had bought CDSs as protection against bond issuers default.
4. A Hedging, and not speculation, in normal functioning markets automatically produces
RWR. Historically, RWR was relatively neglected by institutions for planning purposes. The counterparty default probability is one of the key elements in estimating overall counterparty risk. OTC exposures fluctuate based on market conditions.
5. D Appreciation, and not depreciation, of the yen generated a substantial gain for Japanese
banks with foreign currency swaps positions. A fixed-rate receiver experiences a value gain to the extent that the swap rate declines.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
T h e Ev o l u t io n o f St r e s s T e s t i n g C o u n t e r p a r t y E x p o s u r e s
Topic 32
E x a m F o c u s
In this topic, we take a detailed look at counterparty credit risk measurement and management. We begin by differentiating between the various measures of exposure. Next, we look at the treatment of counterparty credit risk, both as a credit risk and as a market risk. We then review the credit valuation adjustment (CVA) and stresses to the CVA. For the exam, be able to describe a stress test that can be performed on both a loan portfolio and a derivatives portfolio. In addition, ensure that you are able to calculate the stressed expected loss. Finally, be able to calculate stressed CVA and understand how the debt value adjustment (DVA) differs from the CVA.
C o u n t e r p a r t y C r e d i t R i s k E x p o s u r e M e a s u r e s

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