Glossary term
Wrong-Way Risk
Subject: Risk Management, Financial Risk (Credit, Market, Liquidity)
Wrong-way risk arises when the amount a firm stands to lose on a counterparty grows at the same time as that counterparty becomes more likely to default. The two move together, which makes the loss larger than models usually assume.
Explanation
Most credit models treat the exposure and the counterparty's chance of default as independent. Wrong-way risk breaks that assumption. It takes two forms. Specific wrong-way risk comes from the trade itself, for example a company selling protection against its own default or its parent's. General wrong-way risk comes from a shared economic driver, such as a derivative with a counterparty whose business is tied to the same commodity price the derivative is based on. Analysts capture it by modelling the link between exposure and default, by stress testing, and by limiting trades with counterparties whose business is tied to the position. Supervisors expect banks to identify it and to charge capital for it. Credit officers who assume independence will see a modest exposure on such trades at the very moment the counterparty is closest to failing.
Example
Protection against a country's default is bought by a bank from a local bank that is heavily invested in that country's debt. If the country gets into trouble, the protection becomes very valuable to the buyer, but the seller is likely to be hurt by the same event and unable to pay. The bank therefore applies a tighter limit and asks for extra collateral.
Not to be confused with
- Concentration risk
- Concentration risk is too much exposure to one name or sector. Wrong-way risk is exposure that rises just as that counterparty weakens.