Specific Wrong way risk - Università degli Studi di Siena

Gianni Baroncini
Valerio Meloni
 Definition
 Examples
 Regulation
 Measuring
 Management
This type of risk occurs when exposure to a
counterparty is negative correlated with the
credit quality of that counterparty.
 There are two types of wrong-way risk:
- Specific wrong way risk arises through poorly
structured transactions, for example, those
collateralized by own or related party shares;
- General or conjectural wrong way risk arises
where the credit quality of the counterparty may
for non-specific reasons be held to be correlated
with a macroeconomic factor which also affects
the value of derivatives transactions.
 Consider
an investor who takes a long
position in shares of Bank A. To hedge the
investment, the investor buys from Bank
B put options on those shares. If the credit
and capital profiles of Banks A and B are
similar, then the investor is taking on wrong
way risk.
 To
avoid it, the investor should purchase puts
from a counterparty whose credit quality is
independent from Bank A.
 Taking
a long position in an Interest rate
swap, where a counterparty pays variable
and receives a fixed rate, but whose credit
quality is significantly correlated with
interest rates.
 In
this case, an increase in interest rates will
raise both the value of the derivative and the
likelihood of the counterparty defaulting.
 An
institution takes a short position in a
currency with a counterparty based in this
 If a country crisis leads to a counterparty
defaulting, the currency will have a
depreciation. The value of the position will
then have an unexpectedly increase, so a
very high exposure, leading the institution to
experience a potentially severe loss.
Basel II highlighted wrong-way risk as an area which should be
specifically addressed by banks in their risk management practice
as far back as 2001.
However, only in recent time wrong-way risk has become a more
important area for risk managers.
There are a number of reasons for this. In part it is due to the
advancements in credit derivative trading that bring
creditworthiness into the trading book as a market factor. It also
is due to the sub-prime crisis in 2007, the subsequent market
volatility and the increasing attention being paid to credit risk.
Each separated legal entity to which the bank is exposed must be
separately rated.
A bank must have policies acceptable to its supervisor regarding the
treatment of individual entities in a connected group including
circumstances under which the same rating may or may not be
assigned to some or all related entities.
Those policies must include a process for the identification of
specific wrong way risk for each legal entity to which the bank is
Transactions with counterparties where specific wrong way risk has
been identified need to be treated differently when calculating the
EAD for such exposures.
Exposure amount at default, or EAD, is calculated as the product of alpha
times Effective Positive Exposure (EPE), as specified below:
EAD= α x EPE
• Specific wrong way risk
A bank is exposed to “specific wrong-way risk” if future exposure to a
specific counterparty is highly correlated with the counterparty’s
probability of default.
A bank must have procedures in place to identify, monitor and control
cases of specific wrong way risk, beginning at the inception of a trade
and continuing through the life of the trade
• General wrong way risk
Banks must identify exposures that give rise to a greater degree of
general wrong-way risk. Stress testing and scenario analyses must be
designed to identify risk factors that are positively correlated with
counterparty credit worthiness. Such testing needs to address the
possibility of severe shocks occurring when relationships between risk
factors have changed. Banks should monitor general wrong way risk by
product, by region, by industry, or by other categories that are
germane to the business. Reports should be provided to senior
management and the appropriate committee of the Board on a regular
basis that communicate wrong way risks and the steps that are being
taken to manage that risk.
• Credit Valuation Adjustment
Banks will be subject to a capital charge for potential mark-tomarket losses (credit value adjustment – CVA – risk) associated with a
deterioration in the credit worthiness of a counterparty.
• Central Counterparties (Clearing House)
Subject to the completion of the revision of the CPSS-IOSCO standards,
the Committee will apply a regulatory capital enhanced CPSS-IOSCO
standards. The Committee will issue a set of rules relationg to the
capitalisation of bank exposures to central couterparties (CPPs). This
set of standards will be finalised after that an impact study is complete
and after CPSS-IOSCO has completed the update of its standards
applicable to CCPs. The Committee intends for these standards to
come into effect at the same time as other counterparty credit risk
 There
are different models to measure
Wrong-way risk;
 All of theme are a manipulation of
measurement approaches used for credit
risk(CVA, EPE) to consider a positive
correlation between the exposure and the
probability of a default;
 All these methods must be implemented
with a Monte Carlo simulation.
Starting from CVA(credit value adjustment):
CVA  (1  R )  E ( Max (V ( t ), 0 ) T  t ) * h ( t ) * DF ( t ) dt
-V(t) is the replacement value of the derivative at
time t;
-Τ is the time at which Party B defaults;
-h(t) is the probability density function for Τ (i.e.,
the hazard rate function);
-R is the expected recovery rate;
-DF(t) is the risk-free discount factor for time t;
-M is the maturity date of the derivative contract;
-E(Max(V(t),0)|T=t) is called “default option”.
 The
first and simplest method to adjust CVA
is to use “alpha” multiplier to increase the
Expected Net Exposure=E[max(v(t),0)|T=t];
 In
this case the probability of default is still
uncorrelated with the Net Exposure;
 Estimates
of alpha reported by banks range
from 1.07 to 1.10.
The second method to consider Wrong-way risk
into CVA is to create a correlation between h(t)
and the Expected Net Exposure;
 We could write also h(t) as function of V(t):
h ( t )  exp[ a ( t )  b * V ( t )   ]
-b is a constant parameter, which measures the
amount of wrong-way risk in the model;
- a(t) is a function of time;
-σ is a constant measuring the amount of noise;
-ε is a N(0,1).
 The
last method to consider Wrong-way risk
into CVA is the use of Gaussian copula to
create a correlation between time to default
and the Expected Net Exposure;
 The replacement value of the derivative can
be simulated with a shifted lognormal
 The correlation between time to default and
replacement value can be simulated with a
bivariate Gaussian copula[X(t),X(v)].
The outcome of X(t) will be used to tell us when
Party B defaults;
 If Party B does default before the maturity of its
contract with Party A, we observe the value of
X(v). This draw is used to tell us the replacement
value, from Party A’s perspective, of the
derivative contract under a lognormal model;
 A high value for X(v) will result in a replacement
value owed from Party A to Party B;
 Party A’s loss at the time of Party B’s default is
valued as the product of loss-given-default and
the value of a default-contingent option.
Another measurement approach is to manipulate
the EPE(Expected positive Exposure), that is the
expected positive mark-to-market value
averaged over time;
Insert in the model a significant positive
dependency between the probability of
counterparty’s default and the mark-to-market
Monte Paschi Siena during 2010, in order to reduce its
counterparty risk (and so also the wrong way risk), decided to
indirectly join at the central counterpart LCH. Clearnet London
for the OTC activity. The uses of a clearing house is the simplest
way to bear this kind of risk.
More specifically to the wrong way risk, at December 2011, there
was in progress a progectual activity in order to identificate and
manage correctly the wrong way risk.
The management of wrong way risk for Unicredit bank is, respect to
Monte Paschi, in a more advanced state.
Indeed, in respect of “General worng way risk”, Unicredit knows to
have some exposure, but its impact is insignificant, and it is
controlled through the setting of limits.
In respect of “Specific wrong way risk”, the structure of proposed
transactions is carefully reviewed, with special recourse to the
financial instruments that are pledged as collateral. Unicredit does
not accept as collateral financial instruments issued either by the
counterparty in the envisaged transaction or by any affiliated entity
of the counterparty.
Crédit Suisse, is one of the most advanced banks to manage wrong way
risk. Indeed, they have multiple processes that allow them to capture
and estimate wrong way risk.
The first level is “Credit approval and reviews”, in which the Credit Risk
Management division monitor counterparty exposure and its
creditworthiness. Credit limits are sized to the level of comfort the CRM
officer has with the strategy of the counterparty, the level of disclosure
of financial information and the amount of risk mitigation that is
present in the trading relationship (for instance the level of collateral)
The second level is the “Exposure adjusted risk calculation”, in which
trades that feature specific wrong way risk have higher risk weighting
built into the exposure calculation process compared to “right way”
For example, regarding the equity finance, if there is a high relatedness between
the counterparty and the underlying equity, exposure is calculated as full notional
( and so with zero equity recovery).
A third levels the “Wrong way risk monitoring”, regular reporting of
wrong way risk at both individual trade and portfolio level allows
wrong way risk to be monitored and corrective action taken taken by
CRM in the case of heightened concern.
For example, scenario risk reporting in order to capture wrong way risk at the industry
level, a set of defined scenarios are run on the credit portfolio each month.

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