A major related issue to counterparty risk for investment banks is wrong way risk, wrong way risk can significantly impact the extent of counterparty credit risk.

Wrong way risk occurs when the probability of defaults by counterparty is correlated with size exposure to that counterparty.

In other words, the more money owed by the counterparty, the greater the chance the counterparty will default. Wrong way risk can be categorized into general wrong way risk where the change in credit worthiness of the counterparty and the exposure are both driven by general macroeconomic conditions.

For example, a short equity swap position, which wins if equity markets fall, might face general wrong way risk, since if there is a general economic downturn leading to a stock market crash, they would experience a jump in their winning position from the trade, or in other words, a jump in the exposure of the trade, at the same time as the counterparty may be suffering a decrease in its credit worthiness resulting from the economic downturn. Whereas specific wrong way risk is when the risk profile is driven by the specific risk profile of the counterparty or the transaction.

For example, if a bank, so our focus is a bank here.

If a bank entered into an interest rate swap with a company where the company was receiving fixed interest and the company's paying the floating interest leg, an increase in interest rates would increase amounts owed from the company to the bank, great for the bank.

However, if the company also had many other significant variable rate interest loans to pay, they would also have higher interest payments on those loans and the likelihood of the company defaulting on all of their loans increases.

Not good for the bank.

An important tool to manage counterparty risk in general and wrong way, risks specifically is collateral.

This is where the party owing money puts up an asset as security, just in case they default that way.

If a counterparty does default, the party with the risk exposure has an asset of value it can use to cover its losses.

This can be effective when wrong way risk is slow moving, meaning that as the exposure gradually increases and the counterparty's credit quality is slow eroding, more and more collateral is collected from the counterparty to reduce the size of any loss if default does occur.

There is some good news here.

Wrong way risk does not occur on every derivative transaction. The opposite can also occur called right way risk.

This is where as the credit quality of the counterparty deteriorates and the probability of default increases, the size of the exposure falls.

It's important for a bank to fully understand these positions when calculating and assessing their exposure to counterparty risk.