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

A bank buys credit protection through a single-name credit default swap on a corporate loan it holds, with the protection seller being a lightly capitalized insurer. Which risk does the bank mainly introduce through this transfer, even though credit risk on the borrower is hedged?

The bank mainly takes on counterparty risk. The hedge pays only if the protection seller can perform, and a weakly capitalized insurer may fail precisely when the borrower defaults, so the credit exposure is replaced by exposure to the seller rather than eliminated.

  1. ACounterparty risk that the protection seller cannot pay if the borrower defaultsCorrect
  2. BInterest rate risk that rises because the loan's coupon is fixed
  3. CLiquidity risk from the loan being removed from the balance sheet
  4. DReputation risk arising only from the borrower's ratings upgrade

Explanation

Buying protection swaps exposure to the borrower for exposure to the protection seller. If the seller is weak, the hedge may fail exactly when default occurs. The other options are not the main new risk created by the hedge.

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