FRM Part II · FRM Exam Part II · Credit Risk
A bank holds a USD 50 million loan to a corporate borrower and buys single-name credit default swap (CDS) protection on the full notional from a highly rated dealer. Which risk does the bank primarily remain exposed to after this trade?
The bank mainly retains counterparty risk on the protection seller. The CDS shifts the borrower's default risk to the seller, but the bank only gets paid if the seller can honor its obligation. The trade does not remove interest rate risk or transfer legal ownership of the loan.
- ACounterparty risk that the protection seller fails to pay if the borrower defaultsCorrect
- BInterest rate risk that is transferred entirely to the protection seller
- CThe borrower's default risk, which is unchanged by the trade
- DLoss of all voting rights over the loan to the protection seller
Explanation
Buying CDS protection transfers the reference entity's credit risk to the seller but creates exposure to the seller's ability to pay. The default risk of the borrower is largely hedged, not unchanged. A CDS does not transfer interest rate risk or the loan's legal ownership.
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