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

A bank holds a large concentrated loan to a single corporate borrower and wants to lower its exposure to that borrower's default without selling the loan or notifying the borrower. Which credit risk transfer mechanism is most suitable?

Buying a credit default swap referencing the borrower is most suitable. It transfers default risk to the protection seller while the bank keeps the loan and the client relationship, usually without borrower involvement. Assignment requires moving the loan, and equity or interest rate swaps do not hedge credit risk.

  1. APurchasing a credit default swap referencing the borrowerCorrect
  2. BSelling the loan through a loan assignment requiring borrower consent
  3. CRaising additional equity capital
  4. DEntering an interest rate swap with the borrower

Explanation

A CDS lets the bank buy protection on the reference entity while keeping the loan on its books and the borrower relationship intact. A loan assignment transfers the loan itself and generally involves the borrower. Equity and interest rate swaps do not transfer the borrower's credit risk.

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