Financial Risk Manager Part 2

The correct answer is B. Both the hedge fund and the manufacturer face wrong-way risk with respect to their counterparty risk exposure to Bank HJK.

For the hedge fund, as interest rates rise, the credit quality of Bank HJK's borrowers is likely to decline, increasing the credit spread of Bank HJK. This would increase the value of the long put option on Bank PQR that the hedge fund has, since the two banks' performances are highly correlated. As a result, the hedge fund's exposure to Bank HJK would increase at the same time that Bank HJK's credit quality is deteriorating, which is a classic example of wrong-way risk.

Similarly, for the manufacturer, as the credit spread of Bank HJK increases, the credit spread of Bank PQR is also likely to increase due to the positive correlation between credit spreads of different banks in the same market. This would increase the value of the manufacturer's long CDS position on Bank PQR at the same time that Bank HJK's credit quality is declining. Again, this is a case of wrong-way risk, as the manufacturer's exposure to Bank HJK is increasing while Bank HJK's creditworthiness is decreasing.

In contrast, right-way risk would occur if the counterparty's credit quality and the value of the financial contract were moving in the same direction. However, in this scenario, the movements are in opposite directions, hence wrong-way risk.