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

A bank holds a $20 million loan to a corporate borrower and buys single-name CDS protection on the borrower with a notional of $20 million. Which risk does the bank remain exposed to after the hedge, assuming the CDS is documented correctly?

The bank remains exposed to the credit risk of the protection seller. The CDS shifts borrower default risk to the seller, but if the seller cannot pay after a credit event, the hedge fails, so counterparty risk replaces part of the original exposure.

  1. ACredit risk of the protection seller (counterparty risk)Correct
  2. BInterest rate risk on the borrower's equity
  3. CDefault risk of the borrower, which is fully transferred and cannot reappear
  4. DPrepayment risk of the CDS contract

Explanation

Buying CDS transfers the reference entity's default risk to the protection seller, but the bank now depends on the seller to pay on a credit event. This creates counterparty risk. The borrower's default risk is not eliminated in a way that removes dependence on the seller's solvency.

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