Wrong Way Exposure-Are Firms Underestimating Their Credit Risk?

by Arnon Levy of J.P. Morgan Securities

August 25, 1999

Introducing wrong way exposure- Unlike loans, swaps and other forward trades have uncertain credit exposure that depends on the movement of market rates. To place these deals on a comparable basis to loans we need to determine the expected exposure to the counterparty for each future period.

The Expected exposure for a deal at a given future point, is the expected value of MAX(deal value,0) . Market practice is to compute this under the standard distribution assumed when valuing options on underlying rates. Under this distribution, the expected value of the deal is it's forward value. This assumption is valid only as long as the solvency of the counterparty has no relation to the deal's underlying market rates.

For many deals, however, the market rates are correlated to the financial well being of the counterparty. In these cases, the above choice of distribution can lead to a gross underestimation of the exposure and expected loss. Many financial institutions were caught by surprise during the financial crises in South-east Asia and Russia when corporate and sovereign defaults as well as downgrades were accompanied by severe declines in currency values, thus driving exposures and losses well beyond their anticipations.

Published in: RISK, (July 1999).

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Toward a Better Estimation of Wrong-Way Credit Exposure