Explanation:
Wrong-way risk occurs when there is an adverse correlation between the value of a derivative or option and the creditworthiness of the counterparty. In this case, if the value of the put option on GigaBank's stock increases, it suggests that the stock's value is decreasing, which could be associated with a higher risk of default for the counterparty (Alamine Bank).
When purchasing a put option on a bank's stock from another financial institution, there is an increased risk of WWR if the institutions are likely to be impacted by the same economic factors.
Buying a put option on a bank's stock from another bank exemplifies WWR because the credit quality of financial institutions often moves together, especially during economic downturns.
WWR is most pronounced when the underlying reference for a derivative (like the put option on GigaBank's stock) has fortunes that are highly correlated with those of the counterparty (Alamine Bank).
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Q.1982 Cartogenes Investments is contemplating the purchase of a unique over-the-counter put option on GigaBank's stock from Alamine Bank, another financial institution. This decision could potentially be unsuitable, particularly in the context of wrong-way risk. What is the most accurate reason that explains why this move might be considered inappropriate?
A
The put option will only be valuable if the stock of GigaBank goes up, in which case the counterparty’s credit quality will likely be deteriorating.
B
The put option will only be valuable if the stock of GigaBank goes down, in which case the counterparty’s credit quality will likely be improving.
C
The performance of GigaBank and Alamine Bank is likely to be correlated, and an increase in the value of the Put will most likely coincide with a deterioration in the credit quality of Alamine Bank.
D
Such a buy makes him prone to specific risks affecting banks.
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