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

A bank has a USD 200 million loan portfolio and buys CDS protection on USD 150 million notional of one borrower's debt. The loan to that borrower is USD 120 million. The borrower defaults with a recovery rate of 40%, and the CDS pays notional times (1 - recovery). Ignoring premiums, what is the bank's net position on this borrower's exposure (CDS payout minus loan loss)?

The bank gains USD 18 million. The CDS pays 150 million times 60 percent, which is 90 million, while the loan loses 120 million times 60 percent, which is 72 million. The difference arises because the protection notional exceeds the loan exposure, leaving an over-hedge.

  1. AUSD 18 million gainCorrect
  2. BUSD 72 million gain
  3. CUSD 0
  4. DUSD 90 million gain

Explanation

CDS payout = 150 × (1 − 0.40) = USD 90 million. Loan loss = 120 × 0.60 = USD 72 million. Net = 90 − 72 = USD 18 million gain, caused by over-hedging (notional exceeds exposure). The USD 72 million option is only the loan loss.

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