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

A bank has hedged a USD 50 million loan to Firm X with a CDS bought from Dealer D. The loan matures in 7 years, but the CDS has a 5-year maturity. Firm X's credit spreads widen sharply in year 3. Which statement correctly identifies the residual risks of the hedge?

The bank faces a maturity mismatch, leaving the final two years of the seven-year loan unprotected, and it also bears counterparty risk that Dealer D fails to pay. The five-year CDS does not cover the loan's whole life, and the protection is only as good as the seller's credit.

  1. AThere is a maturity mismatch, so the bank is unprotected for the last two years, and it also bears counterparty risk to Dealer DCorrect
  2. BThe hedge is perfect because CDS spreads move with loan values, so only basis risk remains
  3. CThe bank bears only counterparty risk, since the maturity mismatch benefits the protection buyer
  4. DThe bank has no residual risk because the loan remains on its balance sheet and is collateralized by the CDS

Explanation

A 5-year CDS leaves years 6 and 7 unprotected, a maturity mismatch. In addition, the protection payment depends on Dealer D's ability to pay, creating counterparty risk. The other options wrongly claim a perfect hedge or that mismatch is favorable.

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