An Introduction to Wrong Way Risk

Counterparty risks

Counterparty credit risk (CCR) has been honored since the Financial crisis of 2007-08. Its importance in assessing the overall risk and impact on Financial markets has been widely recognized. And with Basel 3 guidance on regulation capital requirements now in full force, this is a high priority area for financial regulators and institutions.

Wrong path risk and right path risk are two types of risks that can occur in the field of consideration credit risk. Wrong way risk can be classified into SWWR (specific wrong way risk) and GWWR (general wrong way risk).

Define good and bad

Assume that counterparty A enters into a transaction with counterparty B. If, during the term of the transaction, counterparty A’s credit exposure to counterparty B increases at the same time as the solvency of counterparty B deteriorates, then we have a wrong way risk (WWR) case. In such a scenario, the credit risk to one counterparty is negatively correlated to the credit quality of the other counterparty and its ability to make payments when due. In other words, the counterparty is more likely to default because it loses more on the trade position.

• Specific risk of false route (SWWR), arises due to specific factors affecting the counterparty, such as a rating demotepoor earnings or litigation.
• General risk of false route (GWWR) – also known as guesswork wrong direction risk – occurs when the trade position is affected by macroeconomic factors As interest ratepolitical unrest or inflation in a particular region.

Risk in the right direction (RWR), on the other hand, is the exact opposite of risk in the wrong direction. When the creditworthiness of the counterparty improves as its payment obligation increases on this trade, this is called risk in a good way.

In CCR, it is a positive risk, meaning that risk in the right direction is good to take while risk in the wrong direction should be avoided. Financial institutions are encouraged to structure their transactions so that they involve risk in the right direction and not risk in the wrong direction. WWR and right-hand pass risk are together referred to as directional pass risk (DWR).

Some conceptual examples

The rest of this article will be devoted to providing examples of the different types of right and wrong path risk that may exist in different scenarios. These examples will use the following framework of companies, their titles and transactions.

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Specific Risk of Misdirection

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Cortana Inc. buys a put option with Alfa Inc (ALFI) stock as the underlying on day 12 of Alfa Inc.

Strike price: $75, expiration: 30 days, type: American put optionUnderlying: ALFI share

On day 24, ALFI fell to $60 due to a downgrade in its rating and the option is in the money. Here, Cortana Inc.’s exposure to Alfa Inc. has increased to $15 (strike price minus current price) at the same time that Alfa Inc. is more likely to default. This is a case of specific risk of misdirection.

General risk of misdirection

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Singapore-based BAC Bank enters into a total return swap (TRS) with Alfa Inc. In accordance with swap agreement, BAC Bank pays the full return on its BND_BAC_AA link and receives a floating rate of LIBOR plus 3% from Alfa Inc. If interest rates start to rise globally, Alfa Inc.’s credit position deteriorates along with its payment Passives to the increase in the BAC bank. This is an example of a transaction with a general risk of misdirection (BAC’s situation is not due to anything specific to its operations, but to the rise in international interest rates).

Straight line risk

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Sparrow Inc. buys a call option with ALFI stock as the underlying on day 1 from Alfa Inc.

Strike price: $65, expiration: 30 days, type: european optionUnderlying: ALFI share

On day 30, the call option is in the money and has a value of $15, which also matches Sparrow Inc.’s exposure to Alfa Inc. During the same period, ALFI stock rallied to $80 due to the winning a major lawsuit against another company. We can see that Sparrow Inc.’s credit exposure to Alfa Inc. has increased as Alfa’s creditworthiness has improved. This is a case of right lane risk, which is a positive or preferred risk when structuring financial transactions.

SWWR in case of secured transaction

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Suppose Cortana Inc. enters into a crude oil futures contract with Sparrow Inc. In this arrangement, both counterparties are required to post collateral when their net position on the transaction falls below a certain value. Further, suppose Cortana Inc. pledges ALFI stock and Sparrow Inc. pledges stock index STQI in guarantee. If Sparrow’s SPRW stock is included in the STQ 200 index, then Cortana Inc. is exposed to reverse risk in the transaction. However, the upside exposure, in this case, is limited to the weight of SPRW stock in STQ 200 multiplied by the trade notional.

Hybrid SWWR-GWWR in case of CDS

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Now let’s move on to a more complicated case of the wrong way risk. Suppose Cortana’s investment arm holds at face value $30 million of BND_BAC_AA structured securities, issued by BAC Bank. To protect this investment from counterparty credit risk, Cortana enters into a credit default swap (CDS) with Alfa Inc. In this agreement, Alfa Inc. provides credit protection to Cortana in the event that BAC bank defaults on its obligations.

However, what if the writer of CDS (Alfa) is unable to fulfill its obligation at the same time as the bank BAC defaults? Alfa Inc. and BAC Bank, being in the same business sector, may be affected by similar macroeconomic factors. For example, during the Great Recession, the global banking sector has weakened, leading to a deterioration in the credit positions of banks and financial institutions in general. In this case, both the issuer of the CDS and the reference bondare negatively correlated to particular GWWR/macro factors and therefore carry the risk of double default for the buyer of CDS Cortana Inc.

The essential

The risk of misdirection arises when credit risk counterparty over the lifetime of a transaction is negatively correlated to the credit quality of the other counterparty. This may be due either to poor structured transactions (specific WWR) or market/macroeconomic factors that simultaneously affect the transaction as well as the counterparty adversely (general or speculative WWR).

There can be different scenarios in which wrong direction risk can occur, and there are regulatory guidelines on how to deal with some of them – such as applying an additional haircut in case of WWR in a trade guarantee or the calculation of exposure in the event of default (EAD) and theoss given by default (LGD).

In an ever-changing financial world, no method or guidance can be completely exhaustive. Hence the responsibility to build a more robust global banking system that can withstand deep economic shocksremains shared between regulators and financial institutions.