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Wrong-way risk arises when a bank’s claim against a counterparty tends to grow as that counterparty becomes more likely to default. General wrong-way risk runs through a market factor that also affects the counterparty’s finances; specific wrong-way risk is built into the transaction’s link to that counterparty. Classify a case only after checking the direction of both the bank’s payoff and the counterparty’s credit risk.
Trace exposure and default separately
Positive exposure is what the counterparty would owe the bank if the transaction were settled at a given point. A weak counterparty alone is insufficient: its weakness must coincide with a larger bank claim. The Basel Framework’s counterparty credit risk definitions distinguish dependence on general market factors from a connection arising through a particular transaction. GARP’s FRM study materials set out the curriculum objectives for counterparty risk.
An illustrative general-risk trade
Suppose a bank buys a cash-settled call on an oil benchmark from a transport company with substantial unhedged fuel costs. At expiry, assume the invented call has a strike of £75 per barrel and the benchmark rises to £90. The company owes the bank £15 per barrel of call payoff. Higher fuel costs could also strain that company’s ability to pay. Both effects follow the wider oil-price move; the option does not reference the transport company’s own credit. This is general wrong-way risk if that fuel-cost exposure materially weakens the company.
The payoff direction is essential. A rise in the benchmark makes this purchased call valuable to the bank. A fall would leave it with no intrinsic payoff at expiry under these assumed terms, even if the counterparty faced some other difficulty. The prices and payoff are illustrative, not market observations.
An illustrative specific-risk trade
Now suppose a listed dealer writes a cash-settled put on its own shares to the bank. Assume an invented strike of £50 per share and a share price of £30 at expiry. The dealer then owes the bank £20 per share. A collapse in the dealer’s own share price can signal distress at the same time the put obligation grows. Here the contract itself names the obligor’s shares, creating a direct counterparty link rather than reliance on a broad market shock. This is specific wrong-way risk.
| Oil call sold by fuel-exposed transport company | Oil rises; call payoff rises | Unhedged fuel costs rise | General |
| Put written by dealer on its own shares | Dealer shares fall; put payoff rises | The reference shares belong to the obligor | Specific |
Avoid the classification trap
First identify what the bank receives and which market move increases its claim. Then name the factor that could make the counterparty less able to pay. If the shared factor is an external market price, assess general wrong-way risk; if the payoff depends directly on the counterparty’s own shares or credit, assess specific wrong-way risk. A market link needs a credible counterparty vulnerability: an oil-price rise, by itself, does not prove every option seller is distressed.
For revision, draw an arrow from the shock to the bank’s positive exposure and another from the same shock to the counterparty’s creditworthiness. The FRM programme overview locates counterparty risk in the programme, while the expected-loss explanation separates exposure from the loss that follows a default.
Sources
- Calculation of RWA for credit risk | Bank for International Settlements · bis.org · Retrieved
- FRM® Study Material, Guide, Books, Practice Exams | GARP · garp.org · Retrieved
