Wrong way risk occurs when exposure by a bank to a counterparty is adversely correlated with the credit quality of that counter-party.
General or conjectural wrong way risk. The credit quality of the counterparty may for non-specific reasons is held to be correlated with a macroeconomic factor which also affects the value of derivatives transactions. E.g.: An example of conjectural wrong way risk is a supposed macroeconomic relationship between declining corporate credit quality and high interest rates: as current economic conditions show (being characterized by rising default rates in a climate of persistently low interest rates), this relationship does not reliably hold.
Arises through poorly structured transactions, for example those collateralized by own or related party shares.
Capital Allocation towards WWR
The nature of general wrong way risk is too indefinite to permit capital to be allocated for this risk. To attempt to do so compromises the principle that regulatory capital should balance simplicity with risk sensitivity and seek to set an adequate overall level. More generally, internal risk management processes, and not capital calculations, are the ultimate source of assurance for risks which, while important to banks’ financial health, are like general wrong way risk inherently complex and judgmental. ISDA Working group believes that the assessment of general wrong way risk should take place via appropriate internal risk management practices, such as scenario analysis, which are able to assess the sensitivity of a bank to wrong way exposure without needing to assess an associated capital number.
In contrast, the ISDA working group feels that specific wrong way risk is in most cases readily identified, and the capital treatment should clearly set exposure at its worst value. Participants to the International Swaps and Derivatives Association (ISDA) working group confirm that the identification and monitoring of this direct risk (such as trading options on its own shares) with worst case correlation between exposure and default is existing practice within their institutions.
Hence, for the treatment of wrong way exposure, the ISDA working group suggests that the definition of wrong way exposure be limited to specific wrong way risk.
– Abhishek Mehta(2009-11)
The author came across this concept as part of his summer internship this year and made a summary concept note of it.