Answers to Questions and Problems in Correlation Risk Modelling and Management

Gunter Meissner

Answers to Questions and Problems of Chapter 1: Correlation Basics: Definitions, Applications and Terminology

1. What two types of financial correlations exist?

   We differentiate (a) static financial correlations, which measure how two or more financial assets are associated within a certain time period, and (b) dynamic financial correlations, which measure how two or more financial assets move together in time.

2. What is “wrong-way correlation risk” or for short “wrong-way risk”?

   Wrong-way risk exists when there is a tendency for both the credit exposure and the credit risk to increase. For example, wrong-way risk exists if Deutsche Bank sells a put on itself. In this case the put buyer has wrong-way risk: if the Deutsche Bank stock decreases in price, the credit exposure increases (since the put is more valuable). But, if the Deutsche Bank stock decreases in price, this typically also means that the default probability of Deutsche Bank increases; hence the credit risk for the put buyer with respect to Deutsche Bank also increases.

3. Correlations can be non-monotonous. What does this mean?

   It means that the value of a variable such as a credit default swap (CDS) or a