FRM Part II · FRM Exam Part II · Credit Derivatives
A bank buys CDS protection on USD 10 million notional from a counterparty. The reference entity's CDS spread widens sharply, and the CDS now has a positive mark-to-market value of USD 1.5 million to the bank. Which statement best describes the bank's exposure to the protection seller?
Current exposure is USD 1.5 million. The protection buyer benefits from spread widening, so the swap is an asset, and that positive mark-to-market is what would be lost, before collateral and netting, if the seller defaulted.
- ACurrent exposure is USD 1.5 million, as the bank would lose this value if the seller defaulted, ignoring collateral and nettingCorrect
- BCurrent exposure is zero, because the bank pays the premium and the seller bears all risk
- CCurrent exposure is USD 10 million, the full notional, in all circumstances
- DCurrent exposure is negative USD 1.5 million, because spread widening hurts the protection buyer
Explanation
A protection buyer gains when spreads widen, so the contract is an asset worth USD 1.5 million. The replacement cost, and so the counterparty exposure, is that value before collateral or netting. Full notional is only lost on a default of the reference entity combined with seller failure and zero recovery.
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