Credit Risk Management Practice Exam

How does collateral impact wrong-way risk when exposures increase gradually?

1. Collateral has no significant impact in this scenario

2. It mitigates the effects of increasing wrong-way risk

3. It results in greater exposure without protection

4. It leads to default risks for the collateral provider

The correct answer is: It mitigates the effects of increasing wrong-way risk

The correct response highlights the mitigating effect of collateral in situations where exposures increase gradually, particularly in the context of wrong-way risk. Wrong-way risk refers to the situation where the exposure to counterparty default risk increases at the same time as the likelihood of default itself increases, leading to a compounded risk. When collateral is in place, it serves as a buffer that can reduce potential losses. As exposures grow over time, having collateral can help secure the financial obligation between parties. For instance, if a counterparty's position deteriorates (where exposure is rising), the presence of collateral could provide immediate recourse in the event of a default, effectively reducing the net risk. Moreover, if the value of the collateral is stable or appreciates, it further shields the parties involved from potential losses, allowing them to manage their exposure in a controlled manner. Thus, the reinforcing nature of collateral, particularly as it relates to rising exposure and wrong-way risk, emphasizes its role in risk management. This understanding underscores the importance of effective collateral management strategies in credit risk scenarios, especially in environments susceptible to rising exposures.