Wrong-Way Risk Part II
Posted: 10 May 2009 | Source: SunGard
In our first whitepaper [found on http://risktech-forum.com/research/wrong-way-risk], we outlined a pragmatic approach to the detection of wrong-way risk situations, combining a numerical analysis of portfolio sensitivities with a judgement-based assessment of counterparties’ business risk sensitivities. In this second paper we extend this argument to demonstrate how credit exposure profiles could be adjusted to reflect elements of wrong-way risk.
Furthermore, we examine whether exposures should be adjusted in Basel II Pillar 1 capital calculations.
Credit exposure is defined as the amount that would be lost if the borrower or counterparty were to default, with no recovery from the subsequent liquidation. This exposure is traditionally measured independently from the quality or nature of the counterparty. A given transaction or portfolio of transactions will generate the same level of exposure no matter who the counterparty is. This view stems from the lending world, where exposure is a known quantity, such as the outstanding loan balance or a contractually committed credit extension by the lender.