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

A bank holds a USD 100 million loan with a 5-year maturity and buys 3-year CDS protection on the full notional, with recovery on default of 40%. The loan defaults in year 4. What is the bank's CDS recovery, and why?

The CDS pays nothing, USD 0, because the 3-year protection expired before the year-4 default. This is maturity mismatch: coverage applies only to credit events within the contract term. Had default occurred inside the term, the payout would be USD 60 million.

  1. AUSD 0, because the protection had expired before defaultCorrect
  2. BUSD 60 million, because the CDS pays notional times loss given default
  3. CUSD 40 million, because the CDS pays the recovery amount
  4. DUSD 100 million, because the CDS covers the full notional

Explanation

A 3-year CDS covers only credit events during its term. Default in year 4 occurs after expiry, so no payment is made. Year-3 protection would have paid USD 60 million (100 x 60%), which is the tempting distractor.

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