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.

The correct answer is A. Wrong-way risk arises when there is a positive default correlation between the reference asset and the CDS counterparty. This means that if the credit default swap (CDS) buyer is exposed to the risk that the default probability of the reference asset and the CDS counterparty are positively correlated, the risk of loss increases. In other words, if the reference asset is more likely to default when the CDS counterparty is also more likely to default, the protection provided by the CDS is less effective, leading to higher risk for the buyer. Option B is incorrect because a lower correlation between assets in a portfolio generally leads to a higher return/risk ratio. Diversification, which is achieved through lower correlations, helps to reduce the overall risk of the portfolio, thus improving the risk-adjusted return. Option C is incorrect because Gaussian copulas are used to measure the static default correlation risk of collateralized debt obligations (CDOs), not for estimating dynamic correlation risk in a portfolio of pairs trades. Pairs trading involves taking long and short positions in two highly correlated securities and is subject to dynamic changes in correlation. Option D is incorrect because correlation risk is not highest during benign market movements. Instead, it is during systemic crises that correlation risk becomes most significant. During these periods, correlations tend to increase and move closer to 1, indicating that assets move in tandem, which can lead to higher risk due to the lack of diversification benefits.

Author: LeetQuiz Editorial Team