Explanation:
Wrong-way risk occurs when exposure to a counterparty increases exactly when the counterparty's probability of default increases. For a Credit Default Swap (CDS) buyer, if there is a positive default correlation between the reference asset (the entity the buyer is protected against) and the CDS counterparty (the entity selling the protection), the counterparty is more likely to default precisely when the reference asset defaults. This leads to the protection being worthless when it is needed the most, exemplifying wrong-way risk.
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A
The buyer of a CDS faces wrong-way risk when there is a positive default correlation between the reference asset and the CDS counterparty.
B
The risk-adjusted return of a portfolio typically increases when correlations of assets in the portfolio increase.
C
Dynamic correlation risk in a portfolio of pairs trades is most appropriately estimated using Gaussian copulas.
D
Correlation risk is highest during periods of relatively benign market movements when correlations are difficult to predict.