Wrong Way Risk
Wrong Way Risk (WWR) is a form of counterparty risk, which arises when the exposure to a counterparty increases when the risk of the counterparty's default increases. For example, a counterparty may post its own bonds as collateral for a margin call. If the counterparty experiences default then the value of its bonds, posted as collateral, would also fall in value thereby reducing the risk.
Wrong Way Risk is a natural and unavoidable consequence of financial markets. There are two different types of wrong way risks - Specific and General. A specific wrong way risk is caused by the specific characteristics of the counterparty such as the example stated above. A general wrong way risk is caused by general macroeconomic conditions. For example, if the economy goes into recession then there is a high probability that the home loan borrower may lose his job and thereby default on the EMIs, while at the same time the value of the property, which is the collateral, may also come down due to decreased economic activity.
WWR exists in all asset classes. The following are some of the examples.
In Credit Default Swaps
There are two parties to a CDS contract - CDS buyer and CDS seller. If the reference entity's credit spread widens then it indicates that there is a higher possibility of default, which increases the CDS buyer's exposure. However, the CDS buyer would not want any increase in the credit spread of the counterparty (CDS seller) because that increases the risk even further and might make the CDS protection worthless. Also, if there is a strong correlation between the reference entity and the counterparty then it makes the exposure even worse.
In Interest Rate Swaps
Let suppose that in an IRS, a counterparty is paying the fixed rate. If the interest rates were to decrease in relation to the floating rate then there is a possibility of wrong way risk for the other counterparty, particularly when there is a strong correlation between the interest rates and credit spread of the counterparty.
Let's suppose we have a put option on an underlying and our counterparty is the issuer of that underlying. The put option is valuable if the price of the stock goes down but that also means that the credit quality of the counterparty might have deteriorated too. It is not necessary that the counterparty is the issuer of the underlying, even the presence of a strong correlation between the underlying and the counterparty is sufficient to cause a wrong way risk.
In FX derivatives
In FX derivatives, the wrong way risk arises when the counterparty credit quality is linked to the strength of its currency. For example, consider an FX Forward in which we are paying GBP and our counterparty is the government of UK. The deterioration of UK's economy would lead to a deterioration of both the credit quality of UK and GBP (the currency). Alternatively, it is possible that the deterioration of GBP might lead to the deterioration of the credit quality and therefore of the UK's economy. Therefore, there exists a wrong way risk in FX derivatives, whether it be FX Forwards, Cross Currency Swaps or other such derivatives.
Mitigation of Wrong Way Risk
Mitigation of wrong way risk is a challenge. Use of appropriate collateral management is one way to handle this risk but not an easy way as the WWR is very timing dependent. Collateral Substitution and Optimisation can be used to mitigate the risk to some extent but understanding when it arises and how quickly to respond requires proper understanding and analysis of the risk.
END OF MY NOTES
First updated on 10th June 2021.