A form of counterparty credit risk, wrong-way risk arises when the exposure to a counterparty increases together with the risk of the counterparty’s default. There are two types of wrong-way risk. Specific wrong-way risk is caused by the specific characteristics of the counterparty or the transaction: for example, if the counterparty posts its own bonds – or bonds of closely linked entities – as collateral. General or conjectural wrong-way risk is caused by general macroeconomic factors that have the same effect on the exposure to a counterparty and on its probability of default. For example, a bank would be exposed to general wrong-way risk if a rise in interest rates increased both its exposure to a counterparty and the risk of the counterparty’s default. In contrast, right-way risk describes a situation in which credit exposure to a counterparty decreases as its creditworthiness worsens. An example would be a gold producer selling gold forward to a bank as a hedge. If the gold price falls, the producer is at greater risk of default; however, the bank’s credit exposure to the producer decreases since the bank is paying fixed and receiving the floating price.
WRONG-WAY RISK (WWR)
