6. Last year, highly capitalized Global Bank materially increased its credit exposure to become the primary creditor to the largest bank, Bank Connected Inc., in Country Iffy. Global expected this increase to add an incremental return to its bottom line. Bank Connected Inc. had received a clean bill of health from a global auditing firm. Global completely hedged its exposure using a total return swap with a hedge fund. The unexpected happened. Country Iffy's government was forced out in a coup. The new government arrested the head of Bank Connected Inc. because the bank had made large loans to relatives of the head of the former government and the proceeds of these loans were no longer in the country. Bank Connected Inc. declared bankruptcy. Global Bank's strategy exposed it to

A. systemic risk.

B. reputation risk.

C. legal risk.

D. model risk.

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A is incorrect. Systematic risk would result in damage to an economy way out of proportion to its effect on one entity. In this case the question is written to result in damage to Global Bank although the government's actions did have an effect on Country A's economy.

B is correct. Here is it clear that management intentionally exposed Global Bank to an unstable economy in the hopes of earning a small return. Although they felt they hedged their exposure, even if a hedge performs as designed, a firm can be negatively impacted in terms of damage to reputation or disruption of business as a result of a low frequency high severity event.

C is incorrect. Legal risk was not a concern, the transaction the bank entered into was legally sound at the time it was transacted. 

D is incorrect. Model risk cannot properly measure the risks associated with low frequency events, and this was the result of poor business judgment on the part of the bank's management, there is no indication the model did not perform appropriately.

(Allen et. al, sections ffice:smarttags" />5.2.2.3 and 5.3 through 5.3.4).

Reference: Value at Risk, Jorion, p. 486