Correct Answer: D

Explanation: Wrong-way risk occurs when the exposure to a counterparty increases precisely when the counterparty's probability of default increases.

• Hedge Fund perspective: The hedge fund bought put options on Bank PQR from Bank HJK. The hedge fund's exposure to Bank HJK increases when Bank PQR's stock price falls (the puts become in-the-money). Since Bank HJK and Bank PQR are highly correlated, a fall in PQR's stock price is likely to be accompanied by a deterioration in Bank HJK's credit quality. Thus, the exposure increases when the counterparty (HJK) is more likely to default. This is wrong-way risk.
• Manufacturer perspective: The manufacturer bought CDS protection on Bank PQR from Bank HJK. The manufacturer's exposure to Bank HJK increases when Bank PQR defaults (triggering the CDS payoff). Because HJK and PQR are highly correlated, if PQR defaults, HJK is also likely to be in severe financial distress and unable to make the CDS payoff. Again, the exposure increases exactly when the counterparty (HJK) defaults. This is also wrong-way risk.

Both counterparties face wrong-way risk.