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P2.T6.917. Wrong way risk (Gregory Ch.17)

Nicole Seaman

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Learning objectives: Describe wrong-way risk and contrast it with right-way risk. Identify examples of wrong-way risk and examples of right-way risk. Discuss the impact of collateral on wrong-way risk. Discuss the impact of wrong-way risk on central counterparties.


917.1. Among its financial positions, Zapex Financial Corporation has written a call, entered into an interest rate swap, and written a credit default swap. Among these (the following) four positions, which is the BEST example of wrong-way risk?

a. Zapex has written (aka, sold) a call option to a counterparty in the same industry
b. Zapex is the fixed-rate payer in an interest rate swap during an economic recovery
c. Zapex has written (aka, sold) a credit default swap (CDS) to counterparty whose credit quality is positively correlated with the reference entity
d. Zapex has a position in a forward currency contract where its mark-to-market gain is positively correlated with the counterparty's default probability

917.2. Gregory refers to the difference between general and specific wrong-way risk (WWR). He specifically illustrates the difference with respect to the following four dimensions (Source: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital, 3rd edition (West Sussex, UK: John Wiley & Sons, 2015)):

I. Factors: Macro-economic versus structural relationships
II. Ease of detection
III. Ability to model; i.e., incorporate into pricing
IV. Risk management: Advisability of retention (or risk) via pricing versus avoidance

When comparing specific WWR to general WWR, which statement is TRUE?

a. Factors: General WWR is based on macro-economic behavior, but Specific WWR is based on structural relationship not often captures via real-world experience
b. Detection: General WWR is hard to detect, but Specific WWR is typically detectable using historical data
c. Modeling: General WWR is difficult to model, but Specific WWR can be incorporated into pricing models
d. Risk management: General WWR should be avoided (because it can be extreme), but Specific WWR should be managed by way of pricing

917.3. Which of the following is TRUE about the impact of wrong-way risk (WWR) on central counterparties (CCPs)?

a. Larger dealers represent right-way risk
b. CCPs are somewhat immune to wrong-way risk (that's why they exist!)
c. CCPs are at risk of wrong-way risk (WWR) because they disassociate credit quality and exposure
d. Their method of collateral acceptance promotes right-way risk with respect to posted collateral

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