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

A bank holds a USD 20 million loan to a corporate borrower and buys single-name CDS protection on that borrower. Which risk does the bank mainly retain after the hedge, assuming the CDS reference entity and the loan obligor are the same?

The bank mainly retains the counterparty risk of the protection seller. The CDS shifts the borrower's default loss to the seller, but the bank is only protected if the seller can pay when default occurs, so the hedge replaces borrower credit exposure with seller exposure.

  1. ACounterparty risk of the protection sellerCorrect
  2. BInterest rate risk of the borrower's industry only
  3. CRisk that the borrower's credit spread will narrow
  4. DRisk that the protection seller will be upgraded

Explanation

Buying CDS transfers the borrower's default loss to the protection seller, but the bank now depends on the seller paying. Therefore counterparty risk is the main residual credit exposure. A narrowing spread or an upgrade of the seller does not create a loss for the protection buyer.

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