Credit Risk Management Practice Exam

What is an example of wrong-way risk?

1. When a counterparty's credit risk decreases

2. When position gains do not materialize due to increased counterparty risk

3. When collateral values increase with exposure

4. When trades are liquidated at favorable market conditions

The correct answer is: When position gains do not materialize due to increased counterparty risk

Wrong-way risk occurs when exposure to a counterparty increases simultaneously with the deterioration of that counterparty's credit quality, leading to a heightened risk of default. Option B accurately captures this concept because it highlights a scenario where position gains fail to materialize due to an increase in counterparty risk. In simple terms, as the financial health of the counterparty worsens, the potential for loss also increases, resulting in greater risk associated with that exposure. In contrast, the other options do not align with the definition of wrong-way risk. For instance, when a counterparty's credit risk decreases, this is generally associated with reduced risk exposure, not an increase in risk. Similarly, if collateral values increase in tandem with exposure, this indicates a strengthening position, thus mitigating risk rather than enhancing it. Lastly, liquidating trades at favorable market conditions does not reflect an adverse relationship between exposure and counterparty risk; instead, it illustrates a beneficial outcome for the market participant involved.