Explanation:
To mitigate wrong-way risk (WWR), Apex Portfolio Management should carefully assess the correlation between the performance of the underlying assets and the counterparty's credit quality. For put options, selecting options on stocks, where the underlying reference is not highly correlated to the counterparty bank, helps minimize WWR. Avoiding foreign exchange (FX) contracts that involve paying in a sovereign entity's local currency when they are trading with entities from the same region is also prudent, as weakening currency coupled with deteriorating credit quality can amplify WWR. These actions help ensure that Apex is not exposed to increased risk when the counterparty's likelihood of default rises.
B is incorrect because choosing put options and FX forwards based on expected currency weakening related to the counterparty's performance would actually increase WWR, not mitigate it. The goal is to reduce the correlation between the exposure and the counterparty's credit quality, which this choice would not achieve.
C is incorrect because structuring cross-currency swaps based on the prophecy of currency strengthening does not necessarily align with mitigating WWR. The focus here should be on the correlation between the credit quality of the counterparty and the currency value, rather than on
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Q.5482 Apex Portfolio Management is strategizing about initiating hedging trades using put options on stocks and cross-currency swaps in foreign exchange markets. Their risk management team is focused on identifying and managing wrong-way risk (WWR) inherent in these types of transactions. What measures can Apex Portfolio Management take to best mitigate WWR when selecting specific contracts for their hedging strategies?
A
They should prefer put options on the stocks of banks other than the counterparty bank, and avoid FX contracts that involve payment in the currency of a sovereign when trading with entities from that region.
B
They should select put options on highly correlated stock indices to the counterparty's performance and choose FX forwards where currency weakening is expected.
C
They should structure cross-currency swaps such that the currency of the sovereign with which they are trading strengthens against their own, aligning with right-way risk.
D
They should predominantly pursue equity call options and avoid put options, as call options represent right-way risk and put options usually contain WWR.