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.
Keywords: Wrong-way risk; Systemic risk; Jump-diffusion process; Asset pricing; Market microstructure
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.