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Wrong Way risk

Wrong Way risk. Gianni Baroncini Valerio Meloni. Wrong way risk. Definition Examples Regulation Measuring Management. Wrong way risk. This type of risk occurs when exposure to a counterparty is negative correlated with the credit quality of that counterparty.

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Wrong Way risk

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  1. Wrong Way risk Gianni Baroncini Valerio Meloni

  2. Wrong way risk • Definition • Examples • Regulation • Measuring • Management

  3. Wrong way risk • This type of risk occurs when exposure to a counterparty is negativecorrelated with the credit quality of that counterparty. • There are two types of wrong-way risk: - Specific wrong way risk arises through poorly structured transactions, for example, those collateralized by own or related party shares; - General or conjectural wrong way risk arises where the credit quality of the counterparty may for non-specific reasons be held to be correlated with a macroeconomic factor which also affects the value of derivatives transactions.

  4. Specific Wrong way risk • Consider an investor who takes a long position inshares ofBank A. To hedge the investment, the investor buysfrom Bank B put options on those shares. If the credit and capital profiles of Banks A and B are similar, then the investor is taking on wrong way risk. • To avoid it, the investor should purchase puts from a counterparty whose credit quality is independent fromBank A.

  5. Generic Wrong way risk • Taking a long position in an Interest rate swap, where a counterparty pays variable and receives a fixed rate, but whose credit qualityis significantly correlated with interest rates. • In this case, an increase in interest rates will raise both the value of the derivative and the likelihood of the counter­party defaulting.

  6. Generic Wrong way risk • An institution takes a short position in a currency with a counterparty based in this country; • If a country crisis leads to a counterparty defaulting, the currency will have a depreciation. The value of the positionwill then have an unexpectedly increase, so a very high exposure, leading the institution to experience a potentially severe loss.

  7. The regulation Basel II highlighted wrong-way risk as an area which should be specifically addressed by banks in their risk management practice as far back as 2001. However, only in recent time wrong-way risk has become a more important area for risk managers.There are a number of reasons for this. In part it is due to the advancements in credit derivative trading that bring creditworthiness into the trading book as a market factor. It also is due to the sub-prime crisis in 2007, the subsequent market volatility and the increasing attention being paid to credit risk.

  8. The regulation Eachseparatedlegalentitytowhich the bankisexposedmustbeseparatelyrated. A bankmusthavepoliciesacceptabletoitssupervisorregarding the treatment ofindividualentities in a connectedgroupincludingcircumstances under which the same rating may or maynotbeassignedto some or allrelatedentities. Thosepoliciesmust include a processfor the identificationofspecific wrong way riskforeachlegalentitytowhich the bankisexposed. Transactionswithcounterpartieswherespecific wrong way riskhasbeenidentifiedneedtobetreateddifferentlywhencalculating the EAD forsuchexposures. Exposureamount at default, or EAD, iscalculatedas the productofalphatimesEffective Positive Exposure (EPE), asspecifiedbelow: EAD=α x EPE

  9. innovationsofbasel III • Specific wrong way risk A bank is exposed to “specific wrong-way risk” if future exposure to a specific counterparty is highly correlated with the counterparty’s probability of default. A bank must have procedures in place to identify, monitor and control cases of specific wrong way risk, beginning at the inception of a trade and continuing through the life of the trade

  10. innovationsofbasel III • General wrong way risk Banks must identify exposures that give rise to a greater degree of general wrong-way risk. Stress testing and scenario analyses must be designed to identify risk factors that are positively correlated with counterparty credit worthiness. Such testing needs to address the possibility of severe shocks occurring when relationships between risk factors have changed. Banks should monitor general wrong way risk by product, by region, by industry, or by other categories that are germane to the business. Reports should be provided to senior management and the appropriate committee of the Board on a regular basis that communicate wrong way risks and the steps that are being taken to manage that risk.

  11. innovationsofbasel III • CreditValuationAdjustment Banks will be subject to a capital charge for potential mark-to-market losses (credit value adjustment – CVA – risk) associated with a deterioration in the credit worthiness of a counterparty.

  12. innovationsofbasel III • CentralCounterparties (Clearing House) Subjectto the completionof the revisionof the CPSS-IOSCO standards, the Committeewillapply a regulatory capital enhanced CPSS-IOSCO standards. The Committeewillissue a set ofrulesrelationgto the capitalisationofbankexposurestocentralcouterparties (CPPs). This set ofstandardswillbefinalisedafterthatan impact studyis complete and after CPSS-IOSCO hascompleted the update ofitsstandardsapplicabletoCCPs. The Committeeintendsforthesestandardsto come intoeffect at the sametimeasothercounterpartycreditriskreforms.

  13. Measurementapproaches • There are differentmodelstomeasureWrong-wayrisk; • Alloftheme are a manipulationofmeasurementapproachesusedforcreditrisk(CVA, EPE) toconsider a positive correlationbetween the exposure and the probabilityof a default; • Allthesemethodsmustbeimplementedwith a Monte Carlo simulation.

  14. Measurementapproaches • Starting from CVA(credit value adjustment): • Where: -V(t) is the replacement value of the derivative at time t; -Τ is the time at which Party B defaults; -h(t) is the probability density function for Τ (i.e., the hazard rate function); -R is the expected recovery rate; -DF(t) is the risk-free discount factor for time t; -M is the maturity date of the derivative contract; -E(Max(V(t),0)|T=t) is called “default option”.

  15. Measurementapproaches • The first and simplestmethodtoadjust CVA istouse“alpha” multiplier to increase the Expected Net Exposure=E[max(v(t),0)|T=t]; • In this case the probability of default is still uncorrelated with the Net Exposure; • Estimates of alpha reported by banks range from 1.07 to 1.10.

  16. Measurementapproaches • The secondmethodtoconsiderWrong-wayriskinto CVA isto create a correlationbetween h(t) and the Expected Net Exposure; • Wecouldwritealso h(t) asfunctionof V(t): • Where: -b is a constant parameter, which measures the amount of wrong-way risk in the model; - a(t) is a function of time; -σ is a constant measuring the amount of noise; -εis a N(0,1).

  17. Measurementapproaches • The last methodtoconsiderWrong-wayriskinto CVA is the useofGaussian copula to create a correlationbetweentimeto default and the Expected Net Exposure; • The replacement value of the derivative can be simulated with a shifted lognormal distribution; • The correlation between time to default and replacement value can be simulated with a bivariate Gaussian copula[X(t),X(v)].

  18. Measurementapproaches • The outcome of X(t) will be used to tell us when Party B defaults; • If Party B does default before the maturity of its contract with Party A, we observe the value of X(v). This draw is used to tell us the replacement value, from Party A’s perspective, of the derivative contract under a lognormal model; • A high value for X(v) will result in a replacement value owed from Party A to Party B; • Party A’s loss at the time of Party B’s default is valued as the product of loss-given-default and the value of a default-contingent option.

  19. Measurementapproaches • Anothermeasurementapproachistomanipulate the EPE(Expected positive Exposure), that is the expected positive mark-to-market value averaged over time; • Insert in the model a significant positive dependency between the probability of counterparty’s default and the mark-to-market value.

  20. Howbanksmanageit • The “Monte dei paschi di siena” case Monte Paschi Siena during 2010, in orderto reduce itscounterpartyrisk (and so also the wrong way risk), decidedtoindirectly join at the centralcounterpart LCH. Clearnet London for the OTC activity. The usesof a clearing house is the simplest way to bear thiskindofrisk. More specificallyto the wrong way risk, at December 2011, therewas in progress a progectualactivity in orderto identificate and managecorrectly the wrong way risk.

  21. Howbanksmanageit • The “Unicredit” case The management of wrong way riskfor Unicredit bankis, respectto Monte Paschi, in a more advanced state. Indeed, in respectof “Generalworng way risk”, Unicredit knowstohave some exposure, butits impact isinsignificant, and itiscontrolledthrough the settingoflimits. In respectof “Specific wrong way risk”, the structureofproposedtransactionsiscarefullyreviewed, withspecialrecourseto the financialinstrumentsthat are pledgedascollateral. Unicredit doesnotacceptascollateralfinancialinstrumentsissuedeitherby the counterparty in the envisagedtransaction or byanyaffiliatedentityof the counterparty.

  22. Howbanksmanageit • The “Créditsuisse” case 1/2 CréditSuisse, isoneof the mostadvancedbankstomanage wrong way risk. Indeed, theyhave multiple processesthatallowthemtocapture and estimate wrong way risk. The first levelis “Creditapproval and reviews”, in which the CreditRisk Management division monitor counterpartyexposure and itscreditworthiness. Creditlimits are sizedto the levelof comfort the CRM officerhaswith the strategyof the counterparty, the levelofdisclosureoffinancial information and the amountofriskmitigationthatispresent in the trading relationship (forinstance the levelofcollateral)

  23. Howbanksmanageit • The “Créditsuisse” case 2/2 The secondlevelis the “Exposureadjustedriskcalculation”, in whichtradesthatfeaturespecific wrong way riskhavehigherriskweightingbuiltinto the exposurecalculationprocesscomparedto “right way” trades. Forexample, regarding the equity finance, ifthereis a high relatednessbetween the counterparty and the underlyingequity, exposureiscalculatedas full notional ( and so with zero equityrecovery). A thirdlevels the “Wrong way riskmonitoring”, regular reportingof wrong way risk at bothindividualtrade and portfolio levelallows wrong way risktobemonitored and correctiveactiontakentakenby CRM in the case ofheightenedconcern. Forexample, scenario riskreporting in ordertocapture wrong way risk at the industrylevel, a set ofdefinedscenarios are run on the credit portfolio eachmonth.

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