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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.
## Explanation **Option A is correct** because wrong-way risk occurs when the probability of counterparty default is positively correlated with the exposure to that counterparty. In the case of a CDS buyer, if there is a positive default correlation between the reference asset (which the CDS is protecting against) and the CDS counterparty, then when the reference asset defaults (increasing exposure), the CDS counterparty is also more likely to default, creating wrong-way risk. **Option B is incorrect** because when correlations between assets in a portfolio increase, diversification benefits decrease, which typically leads to higher portfolio risk and lower risk-adjusted returns, not higher. **Option C is incorrect** because Gaussian copulas assume constant correlations and are not well-suited for estimating dynamic correlation risk in pairs trading. Pairs trading involves mean-reverting relationships that require more sophisticated correlation modeling approaches that can capture time-varying correlations. **Option D is incorrect** because correlation risk is typically highest during periods of market stress and volatility, not during benign market periods. During stress periods, correlations tend to increase dramatically (correlation breakdown), making them more difficult to predict and manage.
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A 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.
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