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Variation of Wrong-Way Risk Management and Its Impact on Security Price Changes

Author

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  • Tetsuya Adachi

    (Economist, Institute for Monetary and Economic Studies, Bank of Japan (currently, Deputy Director, Prudential Standards Office, Supervisory Coordination Division, Supervisory Bureau, Financial Services Agency, Government of Japan, E-mail: tetsuya.adachi@fsa.go.jp))

  • Yoshihiko Uchida

    (Director and Senior Economist, Institute for Monetary and Economic Studies, Bank of Japan (currently, Director, Supervisory Coordination Division, Supervisory Bureau, Financial Services Agency, Government of Japan, E-mail: yoshihiko.uchida@fsa.go.jp))

Abstract

Wrong-way risk arises when an unexpected adverse change in interdependency among financial products or financial variables (such as interest rates, equities, exchange rates, credits, and commodities) triggers huge losses in portfolios. During the global financial crisis of 2007-09, financial institutions suffered huge losses due to the materialization of wrong-way risk. While its importance has been recognized by market participants, however, they have not reached a consensus on how to model and measure it. This paper proposes a method to model wrong-way risk in pricing and risk management and investigate the mechanism in which it can generate booms and busts in security prices. This paper assumes that there exist two types of investors with differing views on the management of the wrong-way risk and that they trade a derivative security with two underlying assets. The prudent (imprudent) investors are supposed to have a heavy (thin) tail structure in the joint distributions of risky assets in their models. This assumption implies that the reservation value on the security held by imprudent investors is higher than that by prudent investors. In this setup, a numerical analysis shows that (1) as time passes from the latest materialization of wrong-way risk and many investors tend to be imprudent, the market price is bidden up; and (2) once the wrong-way risk materializes, many imprudent investors realize the necessity for prudent management of wrong- way risk and thus the price drops suddenly to the lowest level.

Suggested Citation

  • Tetsuya Adachi & Yoshihiko Uchida, 2015. "Variation of Wrong-Way Risk Management and Its Impact on Security Price Changes," IMES Discussion Paper Series 15-E-11, Institute for Monetary and Economic Studies, Bank of Japan.
    • Handle: RePEc:ime:imedps:15-e-11
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    File URL: http://www.imes.boj.or.jp/research/papers/english/15-E-11.pdf
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    References listed on IDEAS

    as
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    Cited by:

    1. Tetsuya Adachi & Takumi Sueshige & Toshinao Yoshiba, 2019. "Wrong-way Risk in Credit Valuation Adjustment of Credit Default Swap with Copulas," IMES Discussion Paper Series 19-E-01, Institute for Monetary and Economic Studies, Bank of Japan.

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    More about this item

    Keywords

    Wrong-way risk; Systemic risk; Jump-diffusion process; Asset pricing; Market microstructure;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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