Credit Risk Management Practice Exam

What characterizes right-way risk?

1. A decrease in exposure as counterparty risk increases

2. Co-movement between risk exposure and default probability generating a decrease in risk

3. Increased counterparty default without changes in exposure

4. A stable relationship between exposure and collateral value

The correct answer is: Co-movement between risk exposure and default probability generating a decrease in risk

Right-way risk occurs when the exposure to a counterparty is positively correlated with the counterparty's credit quality, meaning that as the risk of default decreases, the exposure to that counterparty also decreases. This relationship creates a decrease in overall risk. For instance, if a firm has a lending relationship and the credit quality of the borrower improves, the lender might increase lending exposure, but at a rate that the borrower can maintain without increasing default probabilities. This forms a scenario where the risk diminishes as the counterparty becomes more stable, reflecting positively on the lender’s position in terms of credit risk. In this context, the other options do not accurately characterize right-way risk. The option discussing a decrease in exposure as counterparty risk increases suggests a negative correlation, which contradicts the concept of right-way risk. Increased default without changes in exposure implies a more hazardous situation without the potential for risk mitigation inherent to right-way risk. Finally, a stable relationship between exposure and collateral value does not capture the crucial aspect of co-movement between risk exposure and default probability that characterizes right-way risk.