Chapter 8

Pricing Counterparty Credit Risk, II - Wrong-way Risk

“I never had a slice of bread,Particularly large and wide,That did not fall upon the floor,And always on the buttered side.”

Newspaper in Norwalk, Ohio, 1841.


The last chapter was concerned with pricing counterparty risk under a key simplifying assumption of no wrong-way risk. Wrong-way risk is the phrase generally used to indicate an unfavourable dependence between exposure and counterparty credit quality – i.e. the exposure is high when the counterparty is more likely to default and vice versa. Whilst most derivatives transactions can be considered to have little or no wrong-way risk, its manifestation can be rather subtle and cause a substantial increase in counterparty risk. If wrong-way risk is possible then “right-way” risk must also exist in cases where the dependence between exposure and credit quality is a favourable one. Right-way situations will reduce counterparty risk.

In this chapter we will identify some causes of wrong-way risk and discuss the associated implications on exposure estimation and quantification of counterparty risk. We will consider the impact of wrong-way risk in forward contracts and options and show example approaches to quantifying the exposure in these cases. A significant amount of the chapter will be dedicated to the credit derivatives market since these products due to their very nature will always embed wrong-way risk. We will discuss credit default swaps (CDSs), ...

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