Financial Risk Manager Part 2

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Explanation:

Explanation

Jane is correct that this represents wrong-way risk, and the true CVA-adjusted value will be lower than $24.

Understanding Wrong-Way Risk

Wrong-way risk occurs when exposure to a counterparty is positively correlated with the counterparty's probability of default. In this scenario:

There is a high, positive correlation between the underlying asset price and the credit quality of the option writer
When adverse economic conditions occur:
- Sector asset prices decline (lowering the value of the option for the holder)
- Sector credit quality deteriorates (increasing the probability of counterparty default)

Why This is Wrong-Way Risk

For an option holder, the exposure is highest when the option is in-the-money (when the underlying asset price is favorable). However, in this case:

When the option becomes more valuable (asset price rises), the counterparty's credit quality improves (lower PD)
When the option becomes less valuable (asset price falls), the counterparty's credit quality deteriorates (higher PD)

This means the exposure (option value) and probability of default are negatively correlated from the option holder's perspective, which constitutes wrong-way risk.

Impact on CVA Calculation

Sam's calculation assumes independence between exposure and default probability:

Expected Loss = EPE × PD × LGD = $25 × 10% × 40% = $1
CVA-adjusted value = $25 - $1 = $24

However, with wrong-way risk:

The effective exposure during periods of high default probability is actually higher than the average EPE
The true expected loss will be greater than $1
Therefore, the true CVA-adjusted value will be lower than $24

Why Other Options Are Incorrect

Option A: Incorrect - This is wrong-way risk, not right-way risk
Option B: Incorrect - This is wrong-way risk, and the value should be lower, not higher
Option D: Incorrect - Expected loss IS impacted by correlation between exposure and default probability

In summary, Jane correctly identifies the presence of wrong-way risk, which requires additional adjustment to the CVA calculation, resulting in a lower net option value than Sam's initial estimate of $24.

Explanation:

Explanation

Jane is correct that this represents wrong-way risk, and the true CVA-adjusted value will be lower than $24.

Understanding Wrong-Way Risk

Wrong-way risk occurs when exposure to a counterparty is positively correlated with the counterparty's probability of default. In this scenario:

There is a high, positive correlation between the underlying asset price and the credit quality of the option writer
When adverse economic conditions occur:
- Sector asset prices decline (lowering the value of the option for the holder)
- Sector credit quality deteriorates (increasing the probability of counterparty default)

Why This is Wrong-Way Risk

For an option holder, the exposure is highest when the option is in-the-money (when the underlying asset price is favorable). However, in this case:

When the option becomes more valuable (asset price rises), the counterparty's credit quality improves (lower PD)
When the option becomes less valuable (asset price falls), the counterparty's credit quality deteriorates (higher PD)

This means the exposure (option value) and probability of default are negatively correlated from the option holder's perspective, which constitutes wrong-way risk.

Impact on CVA Calculation

Sam's calculation assumes independence between exposure and default probability:

Expected Loss = EPE × PD × LGD = $25 × 10% × 40% = $1
CVA-adjusted value = $25 - $1 = $24

However, with wrong-way risk:

The effective exposure during periods of high default probability is actually higher than the average EPE
The true expected loss will be greater than $1
Therefore, the true CVA-adjusted value will be lower than $24

Why Other Options Are Incorrect

Option A: Incorrect - This is wrong-way risk, not right-way risk
Option B: Incorrect - This is wrong-way risk, and the value should be lower, not higher
Option D: Incorrect - Expected loss IS impacted by correlation between exposure and default probability

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Sam estimates the probability of counterparty default by the option writer to be 10% with loss given default of 40%, such that the expected loss = `$25` EPE × 10% PD × 40% LGD = `$1`. He concludes that the CVA-adjusted (net of counterparty risk) option price is `$24`. His colleague Jane observes that this calculation assumes no wrong-way risk. But there is a high, positive correlation between underlying asset price and the credit quality of the option writer counterparty: both the counterparty and underlying share a sector that reacts to the same common factors such that adverse economic regimes depress sector asset prices while lowering sector credit quality (and increasing credit spreads). Is Jane correct that the CVA-adjusted option value deserves further adjustment?

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LLeetQuiz

Last updated: February 28, 2026 at 14:03

As the correlation is positive, this is instead right-way risk; but the true CVA-adjusted value remains $24 as there is no adjustment for right-way risk.

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