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

A bank holds a USD 100 million loan portfolio. It buys a first-loss credit-linked note arrangement covering the first USD 5 million of losses from a protection seller who posts USD 5 million in cash collateral. Portfolio losses later total USD 8 million. Which statement is correct?

The protection seller loses USD 5 million, its full first-loss tranche, and the bank bears the remaining USD 3 million. Protection is limited to the USD 5 million of collateral posted, so losses above that return to the bank.

  1. AThe protection seller loses USD 8 million and the bank loses nothing
  2. BThe protection seller loses USD 5 million and the bank bears USD 3 millionCorrect
  3. CThe protection seller loses USD 3 million and the bank bears USD 5 million
  4. DThe bank is fully protected because the collateral is held in cash

Explanation

The seller absorbs the first USD 5 million of losses, capped at the collateral posted. Remaining losses of 8 - 5 = USD 3 million fall on the bank. Reversing the roles gives option three, and the collateral does not extend protection beyond its size.

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