FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms
A bank buys credit protection from a single insurer on a USD 50 million loan portfolio via a CDS. The insurer defaults at the same time as the portfolio's borrowers suffer heavy losses. Which risk best describes why the hedge failed?
The failure reflects wrong-way counterparty risk. The protection seller's creditworthiness deteriorates exactly when the reference credits default, so the payout is least likely to be honored when needed. The scenario gives no maturity mismatch, prepayment or interest rate cause.
- AWrong-way counterparty riskCorrect
- BBasis risk from maturity mismatch only
- CPrepayment risk
- DInterest rate risk
Explanation
The protection seller's default is correlated with the losses it must cover, which is wrong-way risk. Maturity mismatch is not described, and prepayment or interest rate risk do not explain the failure.
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