Wrong Way Risk

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Under Wrong Way Risk is understood in Finance is a positive correlation between the potential credit amount ( english exposure ) and the credit risk of the borrower. Since in the area of risk management z. If, for example, both parameters are typically determined independently of one another to calculate the credit rating adjustment (CVA), the risk in such a case is systematically underestimated.

introduction

The term "Wrong Way Risk" was prominently introduced by the International Swaps and Derivatives Association (ISDA) in a letter dated September 7, 2001. It is defined as "the adverse correlation of an exposure to a particular counterparty with its creditworthiness ". A disadvantageous correlation exists when the correlation between exposure and default probability is positive, because both the increase in exposure and the increase in the counterparty's default probability mean an increase in the credit risk . The ISDA already differentiates between specific and general wrong way risk. Specific wrong way risk arises from poorly structured transactions, but more generally from correlation to macroeconomic factors that do not necessarily have a specific basis in the transaction itself.

Various correlations between the probability of default and exposure with the respective technical term

The opposite term is the “right way risk”, which means an advantageous correlation of the sizes mentioned. If this is the case, the credit risk hardly changes, even under changed market conditions.

Examples

Wrong Way Risk can be better understood by illustrating it. Specific wrong way risk always arises when relationships between different business partners are not sufficiently taken into account. Examples could be:

  • A derivative that is secured by a bond issued by the same company or its subsidiary . If the creditworthiness of the counterparty now falls, the value of the collateral also falls, which increases the exposure.
  • A CDS in which the failure of the protection seller correlates positively with the failure of the third party (against whose failure the CDS should insure). This can happen if the protection seller holds a particularly large number of bonds from the third party.

The definition of general wrong way risk is much more vague. That's why it's difficult to identify. An example:

  • An appreciation of the Swiss franc increases the probability of default for export-oriented Swiss companies. A derivative with the price of the Swiss franc as an underlying , concluded with such a company, can therefore represent a case of general wrong way risk.

meaning

Wrong Way Risk, in particular, is an issue for Credit Score Adjustment (CVA). In general, it is calculated as the product of the probability of default (PD), the amount of default credit (EaD) and the loss of default rate (LGD):

These variables are typically determined independently of one another and thus (implicitly) assumed to be uncorrelated. With Monte Carlo methods, the effects of various market scenarios on the exposure are simulated, but not on the creditworthiness of the counterparty. But if PD and EaD are positively correlated with one another, then the PD would also increase in pessimistic market scenarios. The CVA is then underestimated by the determined value.

Avoiding Wrong Way Risk

Wrong way risks can only be uncovered through a precise analysis of the individual transactions together with a well-maintained database of business partners or through macroeconomic analyzes. A factor was introduced in the Basel III framework that is applied to the exposure in order to counter undetected wrong way risks. This can be determined by the banks themselves, but is at least 1.2. The default is 1.4. In addition, banks are required to continuously examine their own portfolio for general or specific wrong way risks.

Individual evidence

  1. ↑ a b Letter to Richard Gresser from September 7, 2001. In: ISDA. Archived from the original on December 22, 2014 ; accessed on October 5, 2016 .
  2. ↑ a b Johannes Wernz, Bank Control and Risk Management , Berlin / Heidelberg 2012, p. 87.
  3. ^ A b Wrong Way Risk. In: CVA Services GmbH. Retrieved October 10, 2016 .
  4. ^ Strengthening the resilience of the banking sector - Consultative Document. (PDF) In: BIS. December 2009, pp. 29, 43 , accessed on October 5, 2016 (English).