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Answer: The investor has wrong-way risk if there is negative correlation risk between First Bank and Canada.
## Explanation This question involves understanding credit default swaps (CDS) and correlation risk, particularly wrong-way risk. **Analysis of each option:** **Option A:** Incorrect. If correlation between First Bank and Canada increases, the CDS spread value would likely decrease (not increase) because higher correlation means the protection seller (First Bank) is more likely to default when the reference entity (Canada) defaults, making the CDS protection less valuable. **Option B:** Incorrect. While CDS spreads are influenced by the default probability of the reference asset, they are not typically valued based on the joint default correlation between the protection seller and reference entity in standard CDS pricing models. **Option C:** **CORRECT**. Wrong-way risk occurs when the probability of default of the protection seller increases when the reference entity's credit quality deteriorates. Negative correlation between First Bank and Canada creates wrong-way risk because if Canada's credit deteriorates (increasing default probability), First Bank's credit quality would improve (decreasing default probability), making the CDS protection less valuable when it's most needed. **Option D:** Incorrect. Increasing correlation risk actually increases the probability of the worst-case scenario (simultaneous default of both the reference entity and protection seller), not decreases it. **Key Concept:** Wrong-way risk in CDS occurs when there's negative correlation between the protection seller and reference entity, making the protection less effective when it's most needed.
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An investor purchases $1 million of Canadian bonds and is concerned about the bonds defaulting. The investor wishes to transfer this default risk to a third party, so he enters a fixed credit default swap (CDS) spread agreement with First Bank. Assume that the recovery rate is zero and that there is no accrued interest in the event that Canada defaults. Which of the following statements about the CDS between the investor and First Bank is correct?
A
A paper loss occurs for the investor if the correlation risk between First Bank and Canada increases because the value of the CDS spread will increase.
B
The fixed CDS spread is valued based on the default probability of the reference asset and the joint default correlation of First Bank and Canada.
C
The investor has wrong-way risk if there is negative correlation risk between First Bank and Canada.
D
Increasing correlation risk decreases the probability that the worst case scenario occurs.