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Wrong-way Risk

It is possible for the counterparty's credit quality to be co-dependent with the level of exposure. This effect is called wrong-way risk if the exposure tends to increase when the counterparty credit quality gets worse. ISDA (the International Swaps and Derivatives Association) defines wrong-way risk as the risk that occurs when "exposure to a counterparty is adversely correlated with the credit quality of that counterparty". The terms 'wrong-way risk' and 'wrong-way exposure' are often used interchangeably.

An example of this would be a forward contract with a gold producer in which the bank pays the spot price of gold and receives a fixed price. Suppose the price of gold were to decrease. That would worsen the credit quality of the gold producer, since their revenues would decrease, making their business less profitable and viable. It would also increase the value of the forward contract to the bank, since the bank is paying the spot price; therefore, the bank's exposure would increase. If these two effects tend to happen together, then that co-dependence will increase the CVA on the forward contract and it will make the CVA larger than if the effects were independent. The data to quantify these co-dependencies are difficult to obtain, and are ephemeral. But it is important that the CVA framework be able to handle this effect.

Wrong-way risk


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