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FRM Part II · FRM Exam Part II · An Introduction to Securitisation

A bank has bought credit protection on a loan portfolio using a CDS that references a basket of bonds issued by the same obligors, rather than the loans themselves. The CDS pays out only on bankruptcy and failure to pay, and excludes restructuring. Which combination of risks does the bank mainly retain?

The bank retains basis risk and restructuring risk. The hedge references bonds, not its loans, so the protection may not respond to loan losses. Without restructuring as a credit event, a distressed loan restructuring may produce a loss that the CDS does not cover.

  1. ABasis risk from the reference-asset mismatch, and restructuring risk from the missing credit eventCorrect
  2. BInterest rate risk only, because credit risk is fully transferred
  3. CPrepayment risk, because bonds are not callable
  4. DCurrency risk, because CDS contracts settle only in US dollars

Explanation

Referencing bonds rather than the bank's loans creates an asset mismatch, so the loans and bonds may not move in line or default together. Omitting restructuring means a loan restructured under distress may not trigger payment. Both leave residual credit-related loss with the bank.

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