Finance

Wrong Way Risk and its Impact on your Hedge

What is Wrong 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.

 

Types of Wrong Way Risk:

  1. Specific wrong-way risk: Exposure to a specific counterparty is highly correlated with the counterparty’s probability of default.
  2. General wrong-way risk: Exposure to a specific counterparty is highly correlated with the counterparty’s probability of default. Arises when the probability of default of counterparties is positively correlated with general market risk factors.

An unfavourable dependence between two things – Exposure (EA) and Credit Quality of the counterparty i.e. Probability of default (PD) and loss given default (LGD). If the relationship between credit quality and exposure is unfavourable means that it is going to increase the loss much higher because of the above relationship given. That is what we are calling it as wrong way risk.

In case the relationship is favourable as it is reducing the risk then we’ll call it as right way risk.

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Example: 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.

Effect of WWR on Credit Value adjustment (CVA):

  • If these two effects tend to happen together, then that co-dependence will increase the CVA on the forward contract and it will make the CVA larger than if the effects were independent.
  • The data to quantify these co-dependencies are difficult to obtain and are ephemeral. But it is important that the CVA framework be able to handle this effect.
  • Ordinarily, in trading book credit risk measurement, the creditworthiness of the counterparty and the exposure of a transaction are measured and modelled independently.
  • In a transaction where wrong-way risk may occur, however, this approach is simply not sufficient and ignores a significant source of the potential loss.

Impact of Collateral:

  • Collateral can be viewed as a way to reduce exposure. Therefore, when exposure is increasing significantly, it’s 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

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Basel II highlighted the issue of wrong-way risk as an area which should be specifically addressed by banks in their risk management practice as far back as 2001. In recent months however wrong-way risk has come more sharply into focus as an area of concern for risk managers and one that may have been neglected by many.

Author: Yash Tanwar

About Author: Commerce graduate from University of Delhi who is currently pursuing for FRM Part-1 2020. He wants to obtain a stronger track record of result making and gain something new skill sets that are applicable to Finance specifically in risk domain.

 

Related:

What is Sovereign Risk and How to mitigate it?

What is Roll over Risk

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