Credit Risk Management Practice Exam

What would be an example of wrong-way collateral?

1. A forward rate agreement collateralized by cash

2. A payer interest rate swap collateralized with a high-quality government bond

3. A fixed-rate bond secured by a variable-rate loan

4. A simple loan agreement with no collateral

The correct answer is: A payer interest rate swap collateralized with a high-quality government bond

In the context of credit risk management, "wrong-way collateral" refers to a situation where the value of the collateral is negatively correlated with the exposure of the transaction. Essentially, when the borrower's creditworthiness deteriorates, the value of the collateral also declines, increasing the risk that the collateral will not cover the exposure. The correct example of wrong-way collateral is illustrated by the option describing a fixed-rate bond secured by a variable-rate loan. This scenario often creates a mismatch because the financial health of the borrower can diminish, particularly in a rising interest rate environment. If interest rates increase, the variable-rate loan payment obligations rise, potentially leading to default. Consequently, the variable-rate loan’s value may decrease, making it less reliable as collateral for a fixed-rate bond. Thus, the relationship between the collateral and the exposure results in a heightened risk during adverse market conditions, indicating that the collateral is not effectively protecting against the risk it’s intended to secure. This understanding helps grasp why the other scenarios would not qualify as wrong-way collateral. For example, a forward rate agreement collateralized by cash would typically exhibit a strong positive correlation, as cash retains its value regardless of whether interest rates rise or fall. Similarly, a payer interest rate swap backed by a