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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank buys CDS protection on a loan to Firm X from a protection seller, Dealer D. Which statement about the resulting risk position is correct?

The bank swaps its exposure to Firm X for counterparty exposure to Dealer D. If D's credit quality is positively correlated with X's, protection may be least reliable when it is most needed, which is wrong-way risk, so the hedge is not risk-free.

  1. AThe bank has eliminated all credit risk because Firm X's default is fully hedged
  2. BThe bank has replaced exposure to Firm X with counterparty risk to Dealer D, and wrong-way risk exists if D is correlated with XCorrect
  3. CThe bank now bears the loss given default of Firm X through the CDS premium
  4. DThe bank has removed the loan from its regulatory capital calculation automatically

Explanation

CDS protection leaves counterparty risk on the seller; if the seller's creditworthiness is positively correlated with the reference entity, protection may fail when needed (wrong-way risk). Hedging is not total, and capital relief depends on regulatory recognition.

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