Answers / Risk & Compliance

What is wrong-way risk in counterparty credit risk, and why is it especially dangerous?

An advanced Risk & Compliance question — expect it in final rounds and case-heavy interviews (IB, PE, Big-4 Transaction Services).

THE SHORT ANSWER

Wrong-way risk is when a counterparty's default probability is positively correlated with your exposure to it — exposure rises exactly as the counterparty becomes more likely to fail. Specific wrong-way risk is a direct link (e.g., taking a company's own stock as collateral, or a hedge whose value rises as the counterparty's sector collapses); general wrong-way risk is a macro correlation (exposure and default both driven by the same shock). It's dangerous because it breaks the implicit assumption that exposure and creditworthiness are independent — collateral and CVA models that ignore it understate losses, and the loss crystallizes at the worst moment. AIG-style and monoline failures in 2008 were classic: protection sellers defaulted just as the protection became most valuable. You manage it with correlation-aware limits, haircuts, and avoiding self-referencing collateral.

WHAT INTERVIEWERS LISTEN FOR

  • Exposure rises as counterparty default probability rises
  • Specific (direct link) vs general (macro correlation)
  • Breaks independence assumption; models understate loss
  • 2008 monoline/AIG examples; manage via limits/haircuts

COMMON MISTAKES

  • Assuming exposure and default are independent
  • Taking self-referencing collateral
  • Not distinguishing specific vs general WWR

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