D is correct.
The hedge fund has wrong-way risk. As interest rates rise, both Bank HJK’s and Bank PQR’s equity value would decline since the performances of the two banks are highly correlated. Therefore, the value of the long put option on PQR would increase, resulting in a higher exposure to bank HJK for the hedge fund. This is a wrong-way risk since the hedge fund’s exposure to HJK would be increasing as the credit quality of HJK is declining.
The manufacturer also has wrong-way risk. Since the credit spread of Bank HJK is increasing and credit spreads of different banks in the same market tend to be positively correlated, the credit spread of Bank PQR should also increase. Therefore, the value of the manufacturer’s long CDS position on Bank PQR is increasing at the same time the credit quality of Bank HJK is decreasing; thus, that is wrong-way risk.

Learning Objective: Identify examples of wrong-way risk and examples of right-way risk. Describe wrong-way risk and contrast it with right-way risk.

Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital, 4th Edition (West Sussex, UK: John Wiley & Sons, 2020). Chapter 17. CVA