Can you give a clear example of wrong-way risk for a bank trading desk?

Question

AcadiFi · Accepted Answer

Wrong-way risk (WWR) occurs when exposure to a counterparty is positively correlated with the counterparty's probability of default — your losses get bigger precisely when the counterparty is more likely to fail.

**General WWR example — bank sells USD/TRY FX forward to Turkish bank.** Fjordline Bank (Norwegian) sells USD 300M forward to Bosphorus Ticaret Bank (Turkish) on a 1-year contract. Fjordline receives TRY, pays USD at maturity. If the Turkish lira collapses (say TRY/USD moves from 30 to 55), two things happen simultaneously:

1. Fjordline's MtM becomes deeply positive — it will receive undervalued TRY for overvalued USD. Exposure to Bosphorus rises.
2. Bosphorus faces massive losses on its own dollar-denominated liabilities, and its PD rises sharply as Turkish sovereign risk rises.

Exposure and PD move together. This is general WWR because it's driven by macro correlations (TRY depreciation → Turkish bank stress).

**Specific WWR example — bank buys CDS protection on issuer from affiliated dealer.** Meridian Bank buys CDS protection on Oakmere Corp from Oakmere Securities (a subsidiary). If Oakmere Corp defaults, Meridian's exposure to Oakmere Securities spikes (protection payoff) precisely when Oakmere Securities is most likely to fail. Specific WWR is driven by legal/structural linkages.

Mitigation:
- Charge an alpha multiplier on EAD for WWR trades (Basel)
- Exclude WWR trades from netting benefits
- Require higher collateral
- Avoid trading derivatives referencing the counterparty itself

For FRM, know the distinction: general WWR = macro correlation, specific WWR = legal linkage.

Can you give a clear example of wrong-way risk for a bank trading desk?

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