FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms
A bank holds a portfolio of corporate loans and wants to reduce its exposure to credit losses without notifying borrowers or transferring legal ownership of the loans. It also wants to avoid funding a cash purchase by the counterparty. Which tool best fits these objectives?
A credit default swap fits best because it transfers credit risk synthetically. The bank keeps legal ownership of the loans, borrowers are not notified, and no cash purchase price is needed. Loan sales, novation and true-sale securitization all move legal title and usually involve notice or consent.
- ASelling the loans outright through a loan sale
- BBuying protection through a credit default swapCorrect
- CAssigning the loans through novation
- DSelling the loans to a special purpose vehicle that issues notes to investors, with notice sent to borrowers
Explanation
A CDS transfers credit risk synthetically: the bank keeps the loans on its books, borrowers are not notified, and the protection seller does not pay cash up front. Loan sales, novation and true-sale securitization transfer legal ownership and typically involve borrower notification or consent.
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