Wrong Way Risk

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Wrong Way Risk refers to counterparty credit risk that is negatively correlated with the value of the transaction taken with that counterparty. When exposed to wrong way risk, hedging transactions get riskier the more valuable they become.

Unforeseen or under-managed wrong way risk led to liquidity problems for many financial institutions during the sub-prime and related crises in 2007-2008.

Example

Consider an investor who owns shares in Bank A. To hedge that investment, the investor purchases from Bank B put options on those shares. If the credit and capital profiles of Banks A and B are similiar, then the investor is taking on wrong way risk.

As Bank A's credit-worthiness suffers, the shares in Bank A will fall in price and the investor's puts will gain value. As this hedge becomes more valuable, however, the credit-worthiness on Bank B will also suffer, making the puts a riskier hedge. If both banks fail, the hedge will also fail as the investor will lose the value of both the initial share investment and the value of the purchased puts.

To avoid wrong way risk, the investor should purchase puts from a counterparty whose credit-worthiness is independent of that of Bank A.

See Also

Credit Risk

Counterparty Risk

References