Explanation:
A is correct. Wrong-way risk arises when there is a positive default correlation between the reference asset and the CDS counterparty.
B is incorrect. The lower the correlation between the assets in a portfolio, the higher the return/risk (risk-adjusted returns) ratio.
C is incorrect. Gaussian copulas are used to measure the static default correlation risk of CDOs, they would not be used in a portfolio of pairs trades.
D is incorrect. Periods of systemic crises have the highest correlation risk as the change in correlation is often highest in these crises as correlations move closer to 1.
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.
No comments yet.