Credit Risk Management Practice Exam

What impact does wrong-way risk have on central counterparties (CCPs)?

1. It decreases the required margin amounts.

2. It has no effect if managed properly.

3. It may lead to higher initial margins and default fund contributions.

4. It is entirely beneficial for CCP risk management.

The correct answer is: It may lead to higher initial margins and default fund contributions.

Wrong-way risk occurs when there is a negative correlation between the exposure to a counterparty and the creditworthiness of that counterparty. In the context of central counterparties (CCPs), this poses significant challenges for risk management. When a counterparty’s financial condition deteriorates, it is typically accompanied by a reduction in the value of collateral posted against that exposure, thereby increasing the risk. As a result, to mitigate the heightened risk associated with wrong-way situations, CCPs may require higher initial margins and contributions to default funds. This is a prudent measure to ensure that sufficient collateral exists to cover potential losses that might arise in adverse scenarios. The increased margin requirements serve to cushion against the amplified risks and maintain the integrity of the clearing process. This understanding is critical for effective credit risk management, particularly within the operations of CCPs. By requiring higher margins and contributions, CCPs can better prepare for potential adverse market movements that could stem from wrong-way risk exposure.