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

A bank buys credit protection on a $100 million loan portfolio from a single insurer through credit default swaps. The bank later worries that the protection may not pay out in a systemic downturn. Which risk is the bank mainly concerned about?

The bank is concerned about counterparty risk that is correlated with the insured credit events, known as wrong-way risk. If a systemic downturn triggers many defaults, the single insurer may itself be unable to pay, so the hedge fails when it is most needed.

  1. ABasis risk between the loan and the reference bond index
  2. BCounterparty risk, which is highly correlated with the credit events insured againstCorrect
  3. CPrepayment risk on the underlying loans
  4. DModel risk in the tranche correlation assumption

Explanation

Protection sellers concentrated in credit risk may fail exactly when many credit events occur (wrong-way risk), so the hedge may not be honored. Basis risk concerns mismatch between hedge and exposure, prepayment applies to amortizing assets, and tranche correlation is not in a single-name CDS hedge.

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