Explanation:
In a Credit Default Swap (CDS), where Oracle Financial Group is selling protection on its own sovereign, there is a heightened risk of wrong-way risk (WWR). The WWR arises due to the strong relationship between the credit quality of the sovereign and the financial group itself: if the sovereign experiences financial distress, it's likely that Oracle Financial Group, being domiciled in the same sovereign state, would likewise be in distress. This scenario has potential extreme WWR that should be a high priority for review in their risk management practices.
A is incorrect because contracts with commodity producers, such as mining companies using derivatives to hedge price fluctuations, represent right-way risk, not WWR. These contracts typically lead to the commodity producer owing money when prices are high, which is when the business should be more profitable and less likely to default.
C is incorrect because contracts with monoline insurance companies for buying protection can indeed involve significant wrong-way risk, as was evidenced during the global financial crisis. Oracle Financial Group should be concerned about potential WWR in such contracts, especially if the credit quality of the insurance companies is linked to broader financial market distress.
D is incorrect because mortgage-related derivatives during an economic recession would be affected by wrong-way risk, not right-way risk. In a recession, as property prices fall and the credit quality of borrowers decreases, mortgage providers face both increased credit risk and exposure due to these falling asset prices.
Ultimate access to all questions.
No comments yet.
Q.5477 Oracle Financial Group has a diverse portfolio of over-the-counter (OTC) derivatives used for hedging and speculative purposes. Among those, the firm has contracts with sovereigns, monoline insurance companies, and commodity producers as part of their risk management strategy. As part of their annual risk review, the Oracle Financial Group risk committee wants to identify which contracts hold potential wrong-way risk (WWR) and right-way risk (RWR) in order to align their CVA computation practices. Which of the following contracts should be prioritized to review for WWR in the firm’s portfolio?
A
Derivatives contracts with commodity producers, since these contracts are typically characterized by right-way risk arising due to hedging when the business should be more profitable.
B
Credit default swaps (CDS) where Oracle Financial Group is selling protection on its own sovereign, as there is a potential for extreme wrong-way risk due to the strong relationship between the credit qualities.
C
Contracts with monoline insurance companies for buying protection, as there would be no significant wrong-way risk associated due to the unique business model of such entities.
D
Mortgage-related derivatives during economic recessions as these typically represent right-way risk, with exposure reducing as property prices and the credit quality of borrowers decrease.