What's an example of right-way risk for a corporate?

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AcadiFi · Accepted Answer

Right-way risk (RWR) occurs when exposure to a counterparty is negatively correlated with the counterparty's probability of default — when the counterparty is more likely to fail, your exposure is smaller (or zero).

**Corporate example — commodity producer hedging with a consumer.** Kettridge Copper Mines, a Canadian copper miner, sells copper forward to Tanaka Electronics, a Japanese electronics manufacturer, at $9,500/tonne for 2027 delivery. The forward is a private bilateral contract.

If the copper price collapses to $6,000/tonne, two things happen:

1. Kettridge's MtM on the forward is deeply positive (it locked in $9,500 vs spot $6,000). Exposure to Tanaka rises.
2. Tanaka benefits! Its input cost is much lower than the contracted price on this forward, but Tanaka's overall business (which consumes copper) has lower input costs across the board. Tanaka's PD actually falls because its margins improve economy-wide.

Conversely, if copper spikes to $14,000:

1. Kettridge's MtM is negative (it locked in selling at $9,500 vs $14,000 spot). Exposure to Tanaka is zero.
2. Tanaka's input costs spike, margins compress, PD rises.

Exposure and PD move in opposite directions → right-way risk.

Another RWR example: a bank buying CDS protection on a sovereign from a bank that's a net sovereign creditor. If the sovereign deteriorates, the bank seller's PD improves (their claim rises in priority? — actually debatable; cleaner examples come from commodity hedging).

For FRM, know:
- RWR reduces effective exposure and can warrant a negative alpha adjustment (regulators rarely grant this)
- Most bilateral trades are 'neutral' — neither WWR nor RWR
- Identifying RWR requires understanding the economic linkage, not just historical correlation

What's an example of right-way risk for a corporate?

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