The Risks of Counterparties

Counterparty credit risk (CCR) has been in the spotlight ever since the 2007-08 financial crisis. Its importance in assessing overall risk and impact on financial markets has been widely acknowledged. And with the Basel 3 guidelines on regulatory capital requirements now fully in effect, and other guidelines slated to be finalized in 2018-9, this is set to be a high priority area for financial regulators and institutions alike.

Wrong way risk and right way risk are two kinds of risks that might arise within the realm of counterparty credit risk. Wrong way risk can be further classified into SWWR (specific wrong-way risk) and GWWR (general wrong-way risk). 

Defining Right and Wrong

Let's say counterparty A enters into a trade with counterparty B. If, during the life of the trade, the credit exposure of counterparty A to counterparty B increases at the same time that the creditworthiness of counterparty B deteriorates, then we have a case of wrong-way risk (WWR). In such a scenario, the credit exposure to one counterparty is adversely correlated with the other counterparty’s credit quality and ability to make payments when due. In other words, the counterparty is more likely to default as it loses more on the trade position.

  • Specific wrong-way risk (SWWR), arises due to specific factors affecting the counterparty, like a rating downgrade, poor earnings or litigation.
  • General wrong-way risk (GWWR)—also known as conjectural wrong-way risk—occurs when the trade position is affected by macroeconomic factors like interest rates, inflation, or political unrest in a particular region.

Right way risk (RWR), on the other hand, is the exact opposite of the wrong way risk. When counterparty creditworthiness improves as its payment obligation increases on that trade, it is called the right way risk.

In CCR, this is a positive risk, meaning that right way risk is good to take whereas wrong way risk should be avoided. Financial institutions are encouraged to structure their transactions such that they carry right way risk and not wrong way risk. WWR and right way risk are, together, referred to as directional way risk (DWR).

A Few Conceptual Examples

The balance of this piece will be dedicated to providing examples of the various types of right and wrong way risk that may exist in different scenarios. These examples will use the following framework of firms, their securities, and transactions.

Specific Wrong-Way Risk

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Cortana Inc. buys a put option with Alfa Inc's (ALFI) stock as the underlying on day 12 from Alfa Inc.

Strike Price: $75, Expiry: Day 30, Type: American Put Option, Underlying: ALFI stock

On Day 24, ALFI has fallen to $60 due to a downgrade in its rating and the option is in the money. Here, the exposure of Cortana Inc. to Alfa Inc. has increased to $15 (strike price minus the current price) at the same time that Alfa Inc. is more likely to default on its payments. This is a case of specific wrong-way risk.

General Wrong-Way Risk

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BAC Bank, based in Singapore, enters into a total return swap (TRS) with Alfa Inc. As per the swap agreement, BAC Bank pays the total return on its bond BND_BAC_AA and receives a floating rate of LIBOR plus 3% from Alfa Inc. If interest rates start rising globally, then the credit position of Alfa Inc. worsens at the same time that its payment liabilities to BAC Bank increase. This is an example of a transaction carrying general wrong way risk (BAC's situation is due not to anything particular to its operations, but to the international interest-rate rise).

Right-Way Risk

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Sparrow Inc. buys a call option with ALFI stock as the underlying on Day 1 from Alfa Inc.

Strike price: $65, Expiry: Day 30, Type: European option, Underlying: ALFI stock

On day 30, the call option is in the money and has a value of $15, which is also the exposure of Sparrow Inc. to Alfa Inc. During the same period, ALFI stock has rallied to $80 due to a winning a major lawsuit against another firm. We can see that the credit exposure of Sparrow Inc. to Alfa Inc. increased at the same time that Alfa’s creditworthiness improved. This is a case of right way risk, which is a positive or preferred risk when structuring financial transactions.

SWWR in Case of Collateralized Transaction

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Let's assume Cortana Inc. enters into a forward contract on crude oil with Sparrow Inc. In this arrangement, both counterparties are required to post collateral when their net position on the trade falls below a certain value. Further, let's assume that Cortana Inc. pledges ALFI stock and Sparrow Inc. pledges stock index STQI as collaterals. If Sparrow’s stock SPRW happens to be a constituent of the STQ 200 Index, then Cortana Inc. is exposed to wrong-way risk in the transaction. However, the wrong way exposure, in this case, is limited to the weight of SPRW stock in STQ 200 multiplied by the trade notional.

SWWR-GWWR Hybrid in Case of CDS

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Now let's move to a more complicated case of the wrong way risk. Suppose Cortana’s investment arm holds at face value $30 million of structured securities BND_BAC_AA, issued by BAC Bank. To protect this investment from counterparty credit risk, Cortana enters into a credit default swap (CDS) with Alfa Inc. In this arrangement, Alfa Inc. provides credit protection to Cortana in the event BAC Bank defaults on its obligations.

However, what happens if the CDS writer (Alfa) is unable to fulfill its obligation at the same time that the BAC Bank defaults? Alfa Inc. and BAC Bank, being in the same line of business, can be affected by similar macroeconomic factors. For example, during the Great Recession, the banking industry worldwide became weak, leading to worsening credit positions for banks and financial institutions in general. In this case, both the CDS issuer and the reference obligation’s issuer are adversely correlated to particular GWWR/macro factors and hence carry the risk of double-default to the CDS buyer Cortana Inc.

The Bottom Line

Wrong way risk arises when credit exposure of one counterparty during the life of a transaction is adversely correlated to the quality of other counterparty’s credit. This may be either due to poorly structured transactions (specific WWR) or market/macroeconomic factors that simultaneously affect the transaction as well as the counterparty in an unfavorable way (general or conjectural WWR).

There can be different scenarios where wrong-way risk may occur, and there is regulatory guidance on how to tackle some of them – such as the application of additional haircut in case of WWR in a collateralized transaction or the calculation of exposure at default (EAD) and loss given default (LGD).

In an ever-evolving financial world, no method or guidance may be completely exhaustive. Hence, the responsibility of setting up a more robust global banking system, capable of withstanding deep economic shocks, remains shared between regulators and financial institutions.