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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