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FRM Part II · FRM Exam Part II · Credit Derivatives

A bank hedges a loan with a CDS whose reference obligation is a bond of the borrower's parent company, not the borrower itself, and the CDS maturity is two years shorter than the loan. Which risks does this hedge leave the bank with?

The bank retains basis and mismatch risk. The CDS references the parent, not the borrower, so it may not trigger on the borrower's default, and its shorter maturity leaves the final two years of the loan unprotected, making the hedge imperfect.

  1. ABasis risk from the reference mismatch and a maturity mismatch, so the hedge may not pay on a borrower defaultCorrect
  2. BNo residual credit risk, because any CDS eliminates the credit exposure
  3. COnly counterparty risk, since reference and maturity mismatches are irrelevant
  4. DOnly interest rate risk, because the premium is fixed

Explanation

If the borrower defaults but the parent does not, the CDS may not trigger. Also, the borrower can default after the CDS has matured, leaving the loan unprotected. Both are imperfect-hedge (basis and mismatch) risks, in addition to counterparty risk.

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