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Questions:
714.1. According to Jon Gregory, wrong-way risk (WWR) is a subtle but potentially strong effect and further WWR is "often a natural and unavoidable consequence of financial markets." Wrong-way risk (WWR) generally describes an unfavorable co-dependency between exposure and the credit quality of the counterparty. In more exact and operational terms, in a wrong-way risk (right-way risk) the exposure increases (decreases) as the probability of the counterparty's default increases (decreases). In this way, we can either say that wrong-way risk is a positive correlation, or dependence, between exposure and default probability; or equivalently WWR is a negative correlation between exposure and counterparty credit quality.
Which of the following statements is additionally TRUE about wrong-way risk?
a. A simple way to quantitatively incorporate wrong-way risk with an approximation is to estimate CVA with CVA = -EPE * spread
b. Because WWR is specific to transactions and not general, regulations including Basel III in general cannot make strong recommendations regarding quantifying and managing WWR
c. A concrete example of wrong-way risk (WWR) is the buyer (ie, the long position) of a commodity forward contract where the seller (ie, the short position) is a commodity producer--for example a mining company--who is hedging their future commodity sale
d. We can quantitatively and effectively incorporate WWR into the CVA formula at least three ways: by explicitly specifying a dependency between exposure and default; by assuming a conditional exposure; or by assuming a conditional default probability; i.e., linking PD parametrically to exposure
714.2. Since the global financial crisis (GFC), there has been a push for better stress testing of counterparty credit risk (CCR) exposures. In many cases, a financial institution will consider its unilateral credit valuation adjustment (CVA) for stress testing which concerns the fact that its counterparties could default under various market scenarios. But in addition, the financial institution will evaluate its bilateral CVA, which adds the possibility of its own default to counterparties.
According to David Lynch of the Board of Governors of the Federal Reserve, each of the following is true--or at least GOOD ADVICE, EXCEPT which is not true?
a. As regulators shift derivative transactions to central clearing and there are consequently fewer tools to measure and manage CCR, the bank should adopt EITHER a view of CCR as a credit risk or a market risk but not both
b. Although stresses of current exposure are among the most common stress tests used in counterparty credit, stressing current exposure has at least three drawbacks: aggregation of the results is problematic; it does not account for the credit quality of the counterparties; and it provides no information on wrong-way risk
c. For derivatives portfolios, stressed expected loss is likely to include the variable expected positive exposure (EPE), which is the weighted average over time of expected exposures (EE) where the weights are the proportion that an individual expected exposure represents of the entire time interval; and, in turn, expected exposure (EE) is the average of the distribution of exposures at any particular future date before the longest-maturity transaction in the netting set matures
d. The "stress loss" for loan portfolio is the difference between an unconditional expected loss and a stressed EL, EL(s) - EL, and it is the same for a derivatives portfolio except the exposure at default (EAD) variable is replaced by expected positive exposure (EPE) multiplied by an alpha, α, factor; in symbolic terms, EAD --> EPE*α
714.3. Gadgetron has a two-way credit support annex (CSA) with a counterparty covering a portfolio that has just been marked to a value of $1,980,000 or $1.980 million. The collateral terms include the following:
a. -$25,000 (return of $25,000)
b. Zero
c. $225,000
d. $1,210,000
Answers here:
Questions:
714.1. According to Jon Gregory, wrong-way risk (WWR) is a subtle but potentially strong effect and further WWR is "often a natural and unavoidable consequence of financial markets." Wrong-way risk (WWR) generally describes an unfavorable co-dependency between exposure and the credit quality of the counterparty. In more exact and operational terms, in a wrong-way risk (right-way risk) the exposure increases (decreases) as the probability of the counterparty's default increases (decreases). In this way, we can either say that wrong-way risk is a positive correlation, or dependence, between exposure and default probability; or equivalently WWR is a negative correlation between exposure and counterparty credit quality.
Which of the following statements is additionally TRUE about wrong-way risk?
a. A simple way to quantitatively incorporate wrong-way risk with an approximation is to estimate CVA with CVA = -EPE * spread
b. Because WWR is specific to transactions and not general, regulations including Basel III in general cannot make strong recommendations regarding quantifying and managing WWR
c. A concrete example of wrong-way risk (WWR) is the buyer (ie, the long position) of a commodity forward contract where the seller (ie, the short position) is a commodity producer--for example a mining company--who is hedging their future commodity sale
d. We can quantitatively and effectively incorporate WWR into the CVA formula at least three ways: by explicitly specifying a dependency between exposure and default; by assuming a conditional exposure; or by assuming a conditional default probability; i.e., linking PD parametrically to exposure
714.2. Since the global financial crisis (GFC), there has been a push for better stress testing of counterparty credit risk (CCR) exposures. In many cases, a financial institution will consider its unilateral credit valuation adjustment (CVA) for stress testing which concerns the fact that its counterparties could default under various market scenarios. But in addition, the financial institution will evaluate its bilateral CVA, which adds the possibility of its own default to counterparties.
According to David Lynch of the Board of Governors of the Federal Reserve, each of the following is true--or at least GOOD ADVICE, EXCEPT which is not true?
a. As regulators shift derivative transactions to central clearing and there are consequently fewer tools to measure and manage CCR, the bank should adopt EITHER a view of CCR as a credit risk or a market risk but not both
b. Although stresses of current exposure are among the most common stress tests used in counterparty credit, stressing current exposure has at least three drawbacks: aggregation of the results is problematic; it does not account for the credit quality of the counterparties; and it provides no information on wrong-way risk
c. For derivatives portfolios, stressed expected loss is likely to include the variable expected positive exposure (EPE), which is the weighted average over time of expected exposures (EE) where the weights are the proportion that an individual expected exposure represents of the entire time interval; and, in turn, expected exposure (EE) is the average of the distribution of exposures at any particular future date before the longest-maturity transaction in the netting set matures
d. The "stress loss" for loan portfolio is the difference between an unconditional expected loss and a stressed EL, EL(s) - EL, and it is the same for a derivatives portfolio except the exposure at default (EAD) variable is replaced by expected positive exposure (EPE) multiplied by an alpha, α, factor; in symbolic terms, EAD --> EPE*α
714.3. Gadgetron has a two-way credit support annex (CSA) with a counterparty covering a portfolio that has just been marked to a value of $1,980,000 or $1.980 million. The collateral terms include the following:
- Initial margin: $250,000
- Portfolio mark-to-market (MTM) value: +$1,980,000 (from Gadgetron's perspective)
- Threshold: $1,000,000
- Mark-to-market (MTM) of collateral already held: $770,000
- Minimum transfer amount: $100,000
- Rounding: $25,000 (always in favor of Gadgetron; i.e., round up a collateral call, round down a collateral return by Gadgetron)
a. -$25,000 (return of $25,000)
b. Zero
c. $225,000
d. $1,210,000
Answers here:
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