Answer: Wrong-way risk

**D is correct.** The hedge fund has wrong-way risk. As interest rates rise, both Bank HJK's and Bank PQR's equity value would decline since the performances of the two banks are highly correlated. Therefore, the value of the long put option on PQR would increase, resulting in a higher exposure to bank HJK for the hedge fund. This is a wrong-way risk since the hedge fund's exposure to HJK would be increasing as the credit quality of HJK is declining. The manufacturer also has wrong-way risk. Since the credit spread of Bank HJK is increasing and credit spreads of different banks in the same market tend to be positively correlated, the credit spread of Bank PQR should also increase. Therefore, the value of the manufacturer's long CDS position on Bank PQR is increasing at the same time the credit quality of Bank HJK is decreasing; thus, that is wrong-way risk. **Key Concepts:** - **Wrong-way risk**: Occurs when exposure to a counterparty is positively correlated with the counterparty's probability of default - **Right-way risk**: Occurs when exposure to a counterparty is negatively correlated with the counterparty's probability of default - In this case, both counterparties face increasing exposure to Bank HJK at the same time Bank HJK's credit quality is deteriorating

Author: LeetQuiz .