Answer-first summary for fast verification
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.
**Explanation:** 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 if the reference asset defaults, there's a higher probability that the CDS counterparty will also default, making the credit protection less valuable when it's most needed. B is incorrect. The lower the correlation between the assets in a portfolio, the higher the return/risk (risk-adjusted returns) ratio. Higher correlations reduce diversification benefits and typically decrease risk-adjusted returns. C is incorrect. Gaussian copulas are used to measure the static default correlation risk of CDOs; they would not be used in a portfolio of pairs trades. Pairs trading involves dynamic correlation relationships that require more sophisticated modeling approaches. D is incorrect. Periods of systemic crises have the highest correlation risk as the change in correlation is often highest in these crises as correlations move closer to 1. During benign market periods, correlations tend to be more stable and predictable.
Author: LeetQuiz .
Ultimate access to all questions.
A newly hired risk analyst at a large investment bank is examining how financial correlation risk affects the bank's portfolios. The bank holds portfolios consisting of different types of assets and enters into various hedging contracts with multiple counterparties. Which of the following statements would the analyst be correct to make?
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.
No comments yet.