Gregory - Chapter 15 - Wrong-way Risk

[brian.field]

I have read this chapter twice now and it was a struggle! I really don't see much in this chapter that can be tested other than definitional items and, perhaps, a few directional questions asking about how one scenario might increase or decrease wrong-way risk.

Anyone have any thoughts?

Brian

 

[ShaktiRathore]

Wrong way risk is Brian occurs when counterparty on one side of the Tx has exposure to other counterparty that is negatively related to its credit quality i.e. If credit quality of the counterparty decreases the exposure to other counterparty(which bears this wrong way risk) it has increases therefore the ability to pay decreases of the counterparty when its credit quality weakens together with high exposure or its ability to pay worsens in a wrong way risk to pay the net exposure thereby creating high credit risk. Therefore high exposure coupled with low credit quality together deteriorates counterparty's ability to pay. Right way risk is other way even if exposure increases the ability to pay does not worsens because its credit quality improves.
Thanks

 

[brian.field]

Thanks Shakti - I believe I have a good understanding of what wrong-way risk is. I was merely commenting on the lack of easily testable material in Gregory's Chapter 15.

 

[ShaktiRathore]

Yes Brian there is nothing much about wrong way risk that can be tested other than that you should know its basic understanding and whats its that is definition,yes the concept can be tested through several examples or real world scenarios in the exam.
Thanks

 

[Arka Bose]

Hi, in gregory's chapter, at first he says if there is a positive correlation of exposure and default probability (or negative correlation between credit quality and exposure as u guys said it) there will be wrong way risk.
The very next line, he comes to a conclusion saying "Wrong Way risk increases as the credit quality of the counterparty increases'

these two lines are conflicting. @David Harper CFA FRM

 

[David Harper CFA FRM]

Hi @Arka Bose Good to hear from you! Right, the second statement is vexing, to me also, I can't tell you that I yet have a full intuitive grasp of it. The first statement is the easy one: wrong-way risk is a positive (negative) correlation between exposure and default probability (credit quality). In this way, wrong-way (or right-way) risk is some dependence between exposure/EAD and PD. We normally write EL% = PD*EAD but that assumes independence between PD and EAD, so a way to think about WWR is simply when EL > PD*EAD, because EL <> PD*EAD is also a condition for non-independence. Okay, that the obviously true and easier statement.

Hi second statement he illustrates with this XLS https://www.dropbox.com/s/qawyxfx0e8gb1z9/gregory-Chapter15.xlsm?dl=0 where I just added a page and snapshot below. Both have the same assumptions about a forward contract so the blue line is the "normal EE" for the forward contract. On the left is hazard rate (aka, instantaneous conditional PD) = 5% and on the right is hazard rate = 1%; i.e., the graph on the right reflects an increase in credit quality (from PD = 5% to PD =1%). Both graphs assume correlation, ρ(exposure, PD) = 50%. First, neither correlation nor hazard rate has any impact on "normal EE." They impact "wrong-way EE" which is the "conditional EE" being higher than the EE. Both of these panels are consistent with the first, easier statement: WWR is +50% correlation between exposure and PD. But we are now drilling into the first approach that could be used to model the WWR. And this approach to quantifying WWR replaces the unconditional EE (ie, "normal EE" blue line) with a conditional EE ("wrong-way EE", red lines). So we are always here in a situation where WWR is represented by the positive correlation (eg, 50%) but he is is now referring to the quantification of WWR under the approach where a conditional exposure (EE) is calculated to quantify the WWR in the CVA model, and and under his model, the lower PD (1%) implies a higher WW EE line, which is indeed counterintuitive to me. And he explains thusly (emphasis and note mine):

"Let us look into this simple model in a bit more detail. Consider the impact of the counterparty default probability on the EE with WWR. Figure 17.2 shows the EE for differing counterparty credit quality, showing that the exposure increases as the credit quality of the counterparty also increases. This result might seem counterintuitive at first, but it makes sense when one considers that for a better credit quality counterparty, default is a less probable event and therefore represents a bigger surprise when it comes. [david: hmmm ... i see the math, but am not grokking the intuition still!] We note an important general conclusion, which is that WWR therefore increases as the credit quality of the counterparty improves." -- Gregory, Jon. The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital (The Wiley Finance Series) (p. 381). Wiley. Kindle Edition.

 

[Arka Bose]

thanks David, yes all i could understand is that he was referring to conditional EE while making the statement. But still the relationship he stated is still puzzling me. If you come to the terms of it sometime, please do let it come in the notes or in the forum! Thanks a lot!