Wrong-way risk in OTC derivatives and its implication for Japan's financial institutions

Over-the-counter (OTC) derivative transactions, like loans, present the risk of losses in the event that the counterparty goes bankrupt. This is referred to as counterparty risk. OTC derivatives differ from loans, however, in that exposure varies with market factors. The risk that both exposure and the counterparty's default probability will increase at the same time is termed "wrong-way risk", and awareness of which increased during the recent global financial crises. International institutions and market participants have been making progresses in endeavoring to reduce counterparty risk in facing wrong-way risk. The size of the market for OTC derivatives has been growing rapidly, including in Japan, and upgrading the counterparty risk management through strengthened collateral managements has become a pressing matter for the financial institutions that frequently use these transactions.