Wrong Way Risk
Posted: 28 January 2009 | Source: SunGard
Wrong-way risk is defined by the International Swaps and Derivatives Association (ISDA) as the risk that occurs when “exposure to a counterparty is adversely correlated with the credit quality of that counterparty”. In short it arises when default risk and credit exposure increase together. The terms ‘wrong-way risk’ and ‘wrong-way exposure’ are often used interchangeably.
Ordinarily in trading book credit risk measurement, the creditworthiness of the counterparty and the exposure of a transaction are measured and modelled independently. In a transaction where wrong-way risk may occur, however, this approach is simply not sufficient and ignores a significant source of potential loss.
Basel II highlighted the issue of wrong-way risk as an area which should be specifically addressed by banks in their risk management practice as far back as 2001. In recent months however wrong-way risk has come more sharply into focus as an area of concern for risk managers and one that may have been neglected by many.
There are a number of reasons for this. In part it is due to the advancements in credit derivative trading that bring creditworthiness into the trading book as a market factor. It also is due to the sub-prime crisis in 2007, the subsequent market volatility and the increasing attention being paid to credit risk.