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

A bank buys credit default swap protection on a loan portfolio to reduce its exposure to a borrower, with the protection seller being a large insurer. Which additional risk does the bank take on as a direct result of this hedge?

The bank takes on counterparty risk. Buying CDS protection replaces some exposure to the borrower with exposure to the protection seller, so if the seller cannot pay when the borrower defaults, the hedge fails to deliver the expected compensation.

  1. ACounterparty risk that the protection seller fails to pay when the borrower defaultsCorrect
  2. BInterest rate risk that is created by the premium being paid quarterly
  3. CPrepayment risk on the underlying loan
  4. DLiquidity risk that the reference entity cannot be identified

Explanation

Buying CDS protection swaps part of the borrower's credit risk for the credit risk of the protection seller. If the seller fails when the reference entity defaults, the hedge fails. The other options are not the direct new risk created by the hedge.

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