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FRM Part II · FRM Exam Part II · Derivatives

A bank holds a USD 20 million loan to a corporate borrower and buys five-year credit default swap protection on the same reference entity for USD 20 million notional. The CDS is documented with standard terms. Which risk does the bank mainly retain after the hedge?

The bank mainly retains counterparty risk on the protection seller. The CDS transfers the loss from the borrower's default, paying par minus recovery, but the hedge works only if the seller can perform, which is a concern when defaults are correlated.

  1. ALoss from the borrower's default, since CDS does not pay on default
  2. BCounterparty risk that the protection seller fails to perform when the borrower defaultsCorrect
  3. CInterest rate risk from the loan coupon being converted to a fixed rate
  4. DRecovery risk, because the CDS pays only the recovery amount

Explanation

A CDS pays notional minus recovery on a credit event, so the borrower's default loss is largely transferred. What remains is the chance that the protection seller cannot pay, which is most acute when defaults cluster (wrong-way risk). Option A is wrong because the CDS does pay on default; option D reverses the payout, which is par less recovery.

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