The general risk of a wrong path (also known as the presumed wrong path risk) stems from macroeconomic factors that do not specifically affect the counterparty, such as an interest rate shock. The review of this article is devoted to providing examples of the different types of legal and wrong risks that can exist in different scenarios. In these examples, the following framework is used for companies, their securities, and their transactions. If a trader buys a put option on a stock whose performance has a strong positive correlation with the performance of the counterparty, there is an obvious risk of misdirection. Imagine a case where a commercial bank enters into a currency swap with a U.S. (industrial) bank in a developing market like Venezuela. Under the terms of the agreement, the commercial bank (the counterparty) will deliver the developed market currency (USD) in exchange for the local currency. If macroeconomic conditions deteriorate and the value of the local currency decreases (depreciates), the value of the transaction to the U.S. bank increases significantly; Exposure increases significantly. The counterparty must spend more of the local currency to deliver the US dollars as agreed; The risk of default therefore increases. Historically, risk in the wrong way has attracted more attention than risk in the right way, but both types of risk are extremely important. It is imperative that institutions strive to increase the risk of the right track while reducing the risk of the wrong path. It contrasts with Right Way Risk (RWR), which occurs when one party`s payment obligations are positively correlated with the creditworthiness of the same party, thereby reducing the counterparty`s overall credit risk.
In the RCC, this is a positive risk, which means that the risk of the right track is good, while the risk of the wrong track must be avoided. Financial institutions are encouraged to structure their transactions in a way that assumes risk in the right way and not the wrong way. WWR and Right Way Risk are collectively referred to as Directional Way Risk (DWR). 6. Institutions shall report regularly to senior management and the relevant committee of the management body on specific and general risks of misconduct and on the measures taken to manage those risks. Suppose Cortana Inc. enters into a crude oil futures contract with Sparrow Inc. Under this agreement, both counterparties are required to deposit collateral if their net trading position falls below a certain value.
Let`s also assume that Cortana Inc. pledges ALFI and Sparrow Inc. shares the STQI stock index as collateral. If Sparrow`s SPRW stock is in the STQ 200 index, Cortana Inc. may be misguided in the deal. In this case, however, the false exposure is limited to the weight of the SPRW stock in the STQ 200 multiplied by the notional trading value. The risks of false and legal remedies are often observed in practice. Take, for example, the case of a medium-sized bank that holds a large unhedged portfolio of derivatives with a trader. If market variables change in such a way that the value of derivatives is negative for the bank, the bank loses money. If losses accumulate for the bank, it is likely that the bank will not be able to make the necessary payments and therefore default.
When this happens, the value of the portfolio will be positive for the trader and, as a result, the trader`s exposure will increase. This results in a risk of wrong paths for the dealer. The likelihood of the bank failing if it has a significant negative exposure is high. (b) `trajectory specific risk` occurs when future exposure to a particular counterparty is positively correlated with the counterparty`s exposure due to the nature of the transactions with the counterparty. An institution is considered to be exposed to a specific pathway risk if the future exposure to a particular counterparty is likely to be high, while the probability of default of the counterparty is also high. Let us now move on to a more complicated case of risk of misdirection. Let`s assume Cortana`s investment arm holds $30 million worth of structured securities BND_BAC_AA issued by BAC Bank. To protect this investment from counterparty credit risk, Cortana enters into a credit default swap (CDS) agreement with Alfa Inc. In this agreement, Alfa Inc. provides Cortana with credit protection in the event that BAC Bank fails to meet its obligations. 4.
An institution shall maintain procedures to identify, monitor and control cases presenting a specific risk of misconduct for each entity, from the outset of a transaction and throughout the duration of the transaction. B.La general WWR is difficult to model and risky to use given the naïve correlation assumptions. In contrast, law risk describes a situation in which credit exposure to a counterparty decreases with increasing solvency. An example would be a gold producer selling gold to a bank as collateral. If the price of gold falls, the producer is exposed to a higher risk of default; However, the bank`s credit risk vis-à-vis the producer is reduced because the bank pays a fixed price and receives the variable price. A product received by a consumer who wants to cover the price of a product may result in a risk of making a mistake. Wrong Track Risk (RWR), on the other hand, is the exact opposite of risk in the wrong way. If the creditworthiness of the counterparty improves as its payment obligation increases in this transaction, this is called accuracy risk.
However, what happens if the CDS writer (Alfa) is unable to fulfil his obligation at the same time as the bankruptcy of BAC Bank? Alfa Inc. and BAC Bank, which operate in the same sector, may be affected by similar macroeconomic factors. For example, the banking sector weakened globally during the Great Recession, leading to a deterioration in the credit positions of banks and financial institutions in general. In this case, the CDS issuer and the issuer of the benchmark bond are adversely correlated with certain GWWR/macro factors and therefore bear the risk of double default for the buyer of CDS Cortana Inc. In finance, track risk (WWR) occurs when credit risk vis-à-vis a counterparty is negatively correlated with the credit quality of that counterparty.  In other words, the more a party gains on a transaction, the more likely it is that the counterparty will default. This is a source of concern for banks and regulators, as it increases the overall risk of the counterparty. The risk of mistrajectory leads to an increase in counterparty credit risk and therefore increases the CVA.
At the same time, this leads to a reduction in DVA. Headline risk, on the other hand, exists when there is a favourable dependence between exposure and credit quality. In this case, the link between the exposure and the counterparty`s probability of default leads to an overall reduction in counterparty risk. This implies that stroke decreases, but VAD increases at the same time. WWR shall bear the security deposited; Members may reserve high-risk or illiquid securities.