FRM Exam Part II · Portfolio Credit Risk

Credit Risk Mitigation and Portfolio Management for FRM Part II

Updated 11 October 2026 · Fact-checked

Credit risk mitigation reduces a bank's loan portfolio losses using concentration limits, loan sales, credit default swaps, securitization and collateral. To solve questions, identify the exposure, pick the tool that fits, compute the hedged exposure, then check for residual risks such as basis, counterparty and retained tranche risk.

Understand Credit Risk Mitigation and Portfolio Management

A credit portfolio can lose money in two ways: single names default, or many names default together because they share a sector, region or economic driver. Mitigation tools aim at both. Some cut the size of exposures. Others move the risk to someone else.

Limits are the first line of control. A bank caps exposure by borrower, industry, country, rating bucket or product. Concentration limits stop a single shock from causing a loss large enough to threaten capital. Limits are often set as a percentage of capital or of the total portfolio.

Loan sales and secondary trading remove exposure from the balance sheet. The bank gets cash and frees limit and capital. The cost is a lost relationship and possible price discounts, and the buyer may know less than the originator, so adverse selection matters.

Credit derivatives transfer credit risk without selling the loan. In a credit default swap (CDS), the protection buyer pays a periodic spread and receives (1 − recovery) × notional if the reference entity has a credit event. Hedging has limits: basis risk if the CDS reference or maturity differs from the loan, counterparty risk on the protection seller, and a cost that cuts net return.

Securitization pools loans and sells tranches to investors. The originator can pass on risk and raise funding, but if it keeps the first-loss (equity) tranche, most of the expected loss stays with it. Regulators require risk retention to keep incentives aligned. Portfolio managers combine all these tools and judge them by the change in expected loss, unexpected loss, economic capital and return on capital.

Key formulas to remember

CDS payoff on a credit event: Payoff = Notional × (1 − Recovery rate); Paid by the protection seller to the buyer. Assumes cash or physical settlement at the recovery value.
Annual CDS premium: Premium = CDS spread × Notional; Paid by the protection buyer until a credit event or maturity. Spread is quoted in basis points per year; 100 bp = 1%.
Expected loss: EL = PD × LGD × EAD; Use it to measure the benefit of a hedge or sale on the hedged amount.
Net exposure after a hedge: Net exposure = Exposure − Hedged notional; Valid when the hedge matches the exposure. Mismatches leave basis and maturity risk.
Concentration share: Concentration % = Exposure to a name or sector ÷ Total portfolio (or capital); Compare to the limit. A breach needs reduction, sale or hedging.
Net carry on a hedged loan: Net spread = Loan spread − CDS spread; Ignores funding cost and capital. A positive value means the hedge costs less than the loan earns.

How to solve Credit Risk Mitigation and Portfolio Management questions

Use this order for any question on mitigation and portfolio management.

1Identify the risk: single-name, sector or country concentration, or correlation of defaults.
2Note the exposure size, PD, LGD or recovery, and the current limit.
3Match the tool: limit for prevention, loan sale for full removal, CDS for hedging while keeping the loan, securitization for pooled transfer.
4Calculate the effect: the hedged amount, the payoff, the premium or the change in expected loss.
5Identify the residual risks: basis, maturity mismatch, counterparty risk, retained tranche, and adverse selection.
6Judge the economics: cost of protection versus loan spread and capital relief.
7Choose the option that answers exactly what the question asks, such as the most effective or the remaining risk.

Quickest way: Four-line mitigation check

When to use it: For a multiple-choice question with a hedge or sale and a numeric or conceptual answer.

Write the exposure and the hedged notional.
Compute payoff as notional × (1 − recovery), or premium as spread × notional.
Eliminate options that ignore basis, counterparty or retention risk.
Pick the option that matches the tool's true effect: CDS shifts default loss, not market value loss unless priced; securitization with retained first loss keeps most risk.

Common mistakes in Credit Risk Mitigation and Portfolio Management

Using the recovery rate as the CDS payoff.
Students recall the word recovery and stop there.
Fix: Payoff is notional × (1 − recovery). A 40% recovery gives a 60% payoff.
Treating a CDS hedge as risk-free.
The hedge looks perfect on paper.
Fix: Always name the residual risks: counterparty default of the seller, basis risk, maturity mismatch and settlement or definition differences.
Assuming securitization always removes risk.
The loans leave the balance sheet in the diagram.
Fix: Check which tranche the originator keeps. Retaining the equity tranche keeps most of the expected loss.
Treating limits as a hedge.
Both reduce exposure.
Fix: Limits prevent buildup of exposure. Hedges and sales reduce exposure that already exists.
Confusing premium with payoff.
Both are in basis points or percentages of notional.
Fix: The premium is paid regularly by the buyer. The payoff happens once, on a credit event.
Ignoring concentration when diversification is mentioned.
Students assume more names always means less risk.
Fix: Diversification helps only when the names are not highly correlated. Many loans in one sector are still concentrated.

Worked examples

Example 1

A bank holds a $50 million loan to a corporate borrower. It buys CDS protection on $40 million notional at a spread of 150 bp per year. The recovery rate is 35%. (a) What is the annual premium? (b) If the borrower defaults, what does the bank receive from the CDS?

Show the solution

Premium = 1.50% × $40 million = $0.6 million per year.
Payoff = $40 million × (1 − 0.35) = $40 million × 0.65 = $26 million.
The loan is $50 million, so $10 million is unhedged; the loan loses 65% × $50 million = $32.5 million at default.
Net loss = $32.5 million − $26 million = $6.5 million, ignoring premiums paid.

Answer: Annual premium is $0.6 million. The CDS pays $26 million on default, leaving a net loss of $6.5 million before premiums.

Example 2

A bank has a capital base of ₹10,000 crore and a single-sector concentration limit of 15% of capital. Its exposure to one sector is ₹1,800 crore. It plans to sell loans to meet the limit. What is the minimum amount to sell, and what remains the risk if it buys CDS protection instead on the excess at a different reference entity?

Show the solution

Limit = 15% × ₹10,000 crore = ₹1,500 crore.
Excess = ₹1,800 crore − ₹1,500 crore = ₹300 crore.
Selling ₹300 crore of loans brings exposure to the limit.
If it instead hedges the excess with CDS on a different reference entity, the hedge does not match the borrowers, so basis risk remains, and the seller's counterparty risk also exists.

Answer: Minimum sale is ₹300 crore. A CDS on a different reference entity leaves basis risk and counterparty risk, so the hedge may not fully offset losses.

Exam tips

Read the question for whether the risk is single-name or portfolio concentration, since the best tool differs.
Compute with notional × (1 − recovery) and keep units consistent: bp to percent before multiplying.
For securitization questions, look for which tranche is retained and who bears first loss.
Distractors often claim a hedge removes all risk. Look for the option that names a residual risk.
Cost versus benefit questions compare CDS spread with loan spread, then mention capital relief.

Practice questions from Portfolio Credit Risk

Credit Risk Mitigation and Portfolio Management in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Risk Mitigation and Portfolio Management: frequently asked questions

How does a CDS hedge portfolio credit risk?

The bank pays a periodic spread and receives notional × (1 − recovery) if the reference entity has a credit event. It keeps the loan but moves default loss to the seller. Basis and counterparty risk remain.

What is the difference between a loan sale and a CDS hedge?

A loan sale transfers the asset and the risk and gives the bank cash. A CDS keeps the loan on the books and transfers only the credit risk. The CDS keeps the client relationship but adds counterparty risk.

Why do banks use concentration limits?

Limits stop a single name, sector or country from causing a loss large enough to damage capital. They work before exposure builds, unlike hedges, which act on existing exposure.

Does securitization remove credit risk from the originator?

Only to the extent the risk is sold. If the originator retains the first-loss tranche, it keeps most of the expected loss. Risk retention rules also reduce the incentive to originate poor loans.