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Answer: The buyer of a CDS faces wrong-way risk when there is a positive default correlation between the reference asset and the CDS counterparty.
A is correct. Wrong-way risk arises when there is a positive default correlation between the reference asset and the CDS counterparty. This means that the risk of default of the reference asset and the CDS counterparty increases together, which can lead to higher losses for the buyer of the CDS. B is incorrect because a lower correlation between assets in a portfolio typically leads to a higher return/risk ratio, as it allows for better diversification and risk reduction. C is incorrect because Gaussian copulas are used to measure the static default correlation risk of CDOs, not for estimating dynamic correlation risk in a portfolio of pairs trades. D is incorrect because correlation risk is highest during periods of systemic crises when correlations tend to move closer to 1, making them more predictable but also more volatile and potentially leading to higher losses.
Author: LeetQuiz Editorial Team
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A newly hired risk analyst at a prominent investment firm is tasked with evaluating the effects of financial correlation risk on the firm's diverse investment portfolios. These portfolios comprise various types of assets, and the firm is involved in multiple hedging agreements with different counterparties. Which of the following statements would be accurate for the analyst to assert?
A
The buyer of a CDS faces wrong-way risk when there is a positive default correlation between the reference asset and the CDS counterparty.
B
The risk-adjusted return of a portfolio typically increases when correlations of assets in the portfolio increase.
C
Dynamic correlation risk in a portfolio of pairs trades is most appropriately estimated using Gaussian copulas.
D
Correlation risk is highest during periods of relatively benign market movements when correlations are difficult to predict.
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