FRM Part II · FRM Exam Part II · Credit Risk
A bank holds a USD 50 million loan to a corporate borrower and buys protection through a single-name credit default swap (CDS) with the same notional, with the loan as the reference obligation. Which risk does the bank mainly remain exposed to after the hedge, assuming a standard contract?
The bank mainly remains exposed to the protection seller's counterparty risk. The CDS shifts the borrower's default loss to the seller, but payment on a credit event depends on the seller being able to perform, so the credit exposure is substituted rather than eliminated.
- ACounterparty risk of the protection sellerCorrect
- BInterest rate risk removed entirely from the loan
- CThe borrower's default risk, which is fully retained
- DPrepayment risk of the borrower
Explanation
A CDS transfers the reference entity's default risk to the protection seller. The bank's loss on default is then recovered only if the seller performs, so the seller's counterparty risk replaces much of the borrower risk. The borrower's default risk is not retained, so that distractor is wrong.
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