Learning Objectives: Identify examples of wrong-way collateral. Describe the various wrong-way modeling methods, including hazard rate approaches, structural approaches, parametric approaches, and jump approaches. Explain the implications of central clearing on wrong-way risk.
Questions:
24.33.1. Moe's Bank has entered into a credit default swap (CDS) contract with a notional value of $100 million to protect against the default of Sully's Corporation's bonds. As collateral for the CDS, Moe's Bank has accepted $20 million worth of bonds issued by Sully's Corporation's subsidiary, DEF Inc. If Sully's Corporation defaults on its bonds, which of the following scenarios is most likely?
a. The value of the DEF Inc. bonds will increase, fully compensating Moe's Bank for its losses on the CDS.
b. The value of the DEF Inc. bonds will remain stable, providing adequate protection for Moe's Bank's exposure on the CDS.
c. The value of the DEF Inc. bonds will decrease, but the decline will be less than the loss on the CDS, resulting in a partial offset of Moe's Bank's losses.
d. The value of the DEF Inc. bonds will decrease significantly, providing little protection against Moe's Bank's losses on the CDS and potentially amplifying the overall loss.
24.33.2. A financial analyst is evaluating the risk of a portfolio of credit default swaps (CDS) issued by companies in a volatile industry. To account for sudden changes in market conditions, the analyst decides to use a jump approach to model wrong-way risk. Which of the following best describes the advantages and challenges the analyst might face in applying this approach?
a. The jump approach simplifies risk modeling by assuming continuous price movements and does not require complex parameter estimation, making it easier to implement.
b. The jump approach accurately captures sudden and significant market changes, improving the portfolio's risk assessment. However, it increases complexity and requires careful estimation of jump intensities and sizes.
c. The jump approach eliminates the need for stress testing and independent collateral valuation, as it inherently accounts for all possible market scenarios through jumps.
d. The jump approach reduces the need for diversification by assuming that jumps occur independently across different market variables, thus simplifying portfolio management.
24.33.3. The Global Clearing Corporation (GCC) is a central counterparty (CCP) that clears interest rate swaps for its member banks. GCC has recently introduced a new policy allowing member banks to post high-quality corporate bonds as collateral for their interest rate swap positions. Which of the following scenarios best describes the potential impact of this policy change on wrong-way risk?
a. The policy change will eliminate wrong-way risk for GCC, as corporate bonds are not correlated with interest rate swap positions.
b. The policy change will have no impact on wrong-way risk for GCC, as the risk management practices of the CCP remain unchanged.
c. The policy change may increase wrong-way risk for GCC if the accepted corporate bonds are highly correlated with the creditworthiness of the member banks posting them as collateral.
d. The policy change may decrease wrong-way risk for GCC, as corporate bonds are generally less volatile than other forms of collateral, such as cash or government bonds.
Answers here:
Questions:
24.33.1. Moe's Bank has entered into a credit default swap (CDS) contract with a notional value of $100 million to protect against the default of Sully's Corporation's bonds. As collateral for the CDS, Moe's Bank has accepted $20 million worth of bonds issued by Sully's Corporation's subsidiary, DEF Inc. If Sully's Corporation defaults on its bonds, which of the following scenarios is most likely?
a. The value of the DEF Inc. bonds will increase, fully compensating Moe's Bank for its losses on the CDS.
b. The value of the DEF Inc. bonds will remain stable, providing adequate protection for Moe's Bank's exposure on the CDS.
c. The value of the DEF Inc. bonds will decrease, but the decline will be less than the loss on the CDS, resulting in a partial offset of Moe's Bank's losses.
d. The value of the DEF Inc. bonds will decrease significantly, providing little protection against Moe's Bank's losses on the CDS and potentially amplifying the overall loss.
24.33.2. A financial analyst is evaluating the risk of a portfolio of credit default swaps (CDS) issued by companies in a volatile industry. To account for sudden changes in market conditions, the analyst decides to use a jump approach to model wrong-way risk. Which of the following best describes the advantages and challenges the analyst might face in applying this approach?
a. The jump approach simplifies risk modeling by assuming continuous price movements and does not require complex parameter estimation, making it easier to implement.
b. The jump approach accurately captures sudden and significant market changes, improving the portfolio's risk assessment. However, it increases complexity and requires careful estimation of jump intensities and sizes.
c. The jump approach eliminates the need for stress testing and independent collateral valuation, as it inherently accounts for all possible market scenarios through jumps.
d. The jump approach reduces the need for diversification by assuming that jumps occur independently across different market variables, thus simplifying portfolio management.
24.33.3. The Global Clearing Corporation (GCC) is a central counterparty (CCP) that clears interest rate swaps for its member banks. GCC has recently introduced a new policy allowing member banks to post high-quality corporate bonds as collateral for their interest rate swap positions. Which of the following scenarios best describes the potential impact of this policy change on wrong-way risk?
a. The policy change will eliminate wrong-way risk for GCC, as corporate bonds are not correlated with interest rate swap positions.
b. The policy change will have no impact on wrong-way risk for GCC, as the risk management practices of the CCP remain unchanged.
c. The policy change may increase wrong-way risk for GCC if the accepted corporate bonds are highly correlated with the creditworthiness of the member banks posting them as collateral.
d. The policy change may decrease wrong-way risk for GCC, as corporate bonds are generally less volatile than other forms of collateral, such as cash or government bonds.
Answers here:
