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

A bank buys credit protection on a loan using a CDS written by a counterparty with a weak credit rating. Which risk is most directly introduced by this transfer?

Counterparty risk is introduced. The bank replaces borrower default exposure with exposure to the protection seller, who may be unable to pay if the reference entity defaults. A weakly rated seller makes this risk larger, and the transfer does not remove risk completely.

  1. ACounterparty risk, because the protection seller may fail to pay when the reference entity defaultsCorrect
  2. BInterest rate risk, because the CDS fixes the loan coupon
  3. CLiquidity risk of the reference entity only, because CDS has no default exposure
  4. DBasis risk eliminated entirely, since CDS always matches the loan

Explanation

Buying protection swaps exposure to the borrower for exposure to the protection seller. Losses occur if the borrower defaults and the seller cannot perform. The weak rating of the seller increases this risk. Basis risk generally remains rather than being eliminated.

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