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THEEDGE mal aysia   |  march 14, 2011 45

derivatives world

Wrong way risk: a primer

W
rong way risk is now an
important subject in con-
temporary risk manage- by A simple credit guarantee arrangement. Arrows show
ment circles. Wrong way Jasvin Josen transfer of credit risk
risk is a hazard that is al-
ways present in the credit
world but usually brushed off as negligible risk through a variety of other contractual
and remote. It is surprisingly easy to under- mechanisms like credit default swaps, total
stand but difficult to quantify. This article return swaps and credit linked notes.
will introduce the risk as plainly as possible Let us consider a bond issued by a com-
and gradually move towards some quantifi- pany which is guaranteed (or wrapped) by a
cation and valuation issues. guarantor. Here, bond holders have made a
If I were to borrow some money from you, loan to the company and obtained protec-
you would be concerned about my ability to tion against default losses associated with
repay.What is the probability that I will default that loan. The chart (right) illustrates this.
on the loan? Here, you are trying to assess the As a result, the bond carries a higher credit
default risk or the exposure of the loan. Now, rating. The borrower company would have to
if I get ABC to guarantee my loan to you, how pay a fee to the guarantor (who must have
would you assess the exposure? If I default on very good credit standing) for this credit
the loan, ABC steps in to repay my loan. You enhancement.
will probably be more interested in ABC’s
credibility because ABC is now the ultimate Wrong way risk
borrower. You will also feel more comfortable ISDA’s (International Swaps and Deriva-
in valuing the loan since ABC is expected to tives Association) definition of wrong way
have a better credit standing. risk is a risk that occurs when an exposure
Nothing to worry about so far, or is there? to a counterparty is adversely correlated to
What if ABC defaults together with me? What the credit quality of that counterparty. To
if ABC defaults before I do? Consider the sce- illustrate with an extreme example, Bank A quantified. Specific wrong way risk involves probability of default will be dangerously
narios below: enters into a reverse repo (essentially just a mainly higher risk weights as an incentive for underestimated.
a) ABC is actually a company where I am the collateralised loan) with Bank B (the coun- banks to move trades to central counterpar-
main shareholder. Here, the borrower and terparty). The collateral that Bank B provides ties and away from over-the-counter trades. Conclusion
the guarantor are the same. happens to be other bonds that are also is- As for the general part of this risk, procedures Danajamin Nasional Berhad is Malaysia’s only
b) ABC and I are closely related – spouses or sued by Bank B. If Bank B is unable to repay involved are stress testing scenarios and simu- official bond guarantee agency at present. It
business partners. If I were a company,ABC its loan, the collateral will not help either. lations involving longer time periods. is in its early days and started with the moral
could be my holding company. Here, you Bank A should rightfully assign zero value obligation to ensure smaller corporations get
will see that some market or economic to this guarantee. The valuation of wrapped bonds the opportunity to assess debt capital markets.
factors could affect ABC and me simulta- The above is an example of specific wrong predicament However, it is worth pointing out that various
neously. There is a chance that both ABC way risk. There is also a more general form In valuing an illiquid bond that is guaran- possibilities could occur along the time line as
and I will default together. of wrong way risk (referred to as general teed by a guarantor, the norm would be to the numbers of guarantees grow and competi-
c) ABC and I are not related but our busi- conjectural wrong way risk). This risk arises take the credit curve of the guarantor (as- tion intensifies in the marketplace.
nesses are in the same industry. Hence where the credit quality of the counterparty suming that there is a CDS market for the In a financial market that is increasingly
we are exposed to the same market fac- may, for non-specific reasons, be correlated guarantor) and use that as a discount rate to getting more globalised and losing country
tors. For example, if we were in the airline with other macroeconomic factors that may value the wrapped bond. borders, wrong way risk will possibly grow
industry, a sudden rise in fuel cost would also impact the exposure of transactions. However, this assumes that we are only to become more significant. Oversights may
increase my default risk and, at the same These transactions can range from a simple looking at the probability of default of the occur in quantifying this risk but ignoring it
time, ABC’s credibility as a guarantor. The collateralised loan or bond to various types guarantor. Actual default only occurs when all together would be a bigger mistake.
default risk that you hedged with a guar- of over-the-counter derivatives such as for- both the issuer and guarantor default, that is,
antee is now moving the wrong way. wards, swaps and options. The counterparty a joint default probability, which is smaller. Jasvin Josen is a specialist in developing
d) ABC guarantees a lot of borrowers in the and the underlying issuer may be in a similar But in many cases, the bond issuer and the methodologies for valuation of various
same business as mine. Here, the guarantor industry, or the same country or geographi- guarantor are not mutually exclusive, which derivative products. She has over 10 years’
faces concentration risk. In an unfavourable cal region, for instance. means that their probability of default is experience in investment banking and
market turn, ABC may not be able to take It is this general form of wrong way risk correlated with each other. This involves the financial industry in Europe and Asia.
over all the loans at once and hence will de- which is of particular concern as it is both conditional probabilities. Here is where Comments: jasvin@gmail.com. Readers may
fault as well. Even if my business manages difficult to detect in the trading book, hard wrong way risk must be seriously taken also follow her at http://derivativetimes.
to withstand the adverse market event,ABC to measure and complex to resolve. into account or the final estimated joint blogspot.com.
would have defaulted before I did.
e) ABC’s guarantees could also be concentrat- Quantifying wrong way risk and Basel III
ed in a business or industry different from In practice, the exposure to a transaction
mine. Here, if a market event unrelated to and credit worthiness of counterparties are
my business occurs, there is again a chance measured and modelled independently. Of
that ABC may default before me. late, there has been more pressure to as-
One would think that ABC would surely sess this together. In a transaction where
have built-in limits to manage concentration wrong way risk occurs, this approach is not
risk and the amount of loans guaranteed over sufficient and ignores a significant source
its capital. In reality, everyone was happy withof potential loss.
this assumption, even the rating agencies To explain this, if I have a credit default
that continued with the AAA rating for MBIA swap (CDS) with Counterparty A, the mar-

13x3
Inc and AMBAC Financial Group Inc in the ket risk management division measures
US in 2007. Both MBIA and AMBAC were on the CDS exposure in relation to the various
the brink of collapse as a result of the credit market factors and the credit risk manage-
crisis. Their risk of these monolines (bond ment would monitor the amounts owing in
insurers in a specific industry) was concen- aggregate to Counterparty A. Say Counter-
trated in the mortgage industry. Moreover, party A is a major bank and the underlying
they underestimated the default risk of the bond of the CDS is also a major bank. A crisis
loans that were being guaranteed, which in the banking industry would significant-
caused them to guarantee a huge amount of ly affect the value of the CDS. If I were the
loans over and above their capital. protection buyer of the CDS, I would profit
The monoline case has helped to highlight from the change in value and Counterparty
the ad hoc approach of many financial in- A will have to make a payment to me. But
stitutions in thinking about this risk. Some since Counterparty A is also in the banking
were unaware of the potential risk they were industry, it would also be hit by the crisis
running while others chose to ignore it, as- and would not be able to pay. This was the
suming that the worst-case scenario would classic horror that banks experienced when
or could not occur. they had huge exposures with Lehman when
it collapsed in 2007.
What is a financial guarantee? Basel has long recognised this source of
A financial guarantee is a traditional method risk and in its latest standard, both specific
of transferring risk. Parties can also transfer and general wrong way risk is attempted to be