FRM Part II · FRM Exam Part II · Credit Risk Management
A bank holds a USD 50 million loan to a corporate borrower and wants to remove the default risk of this exposure while keeping the loan on its books and retaining the client relationship. Which instrument is most directly suited to this objective?
Buying protection through a single-name credit default swap is the right choice. It compensates the bank if the borrower defaults, so credit risk is transferred while the loan stays on the balance sheet and the client relationship is kept. Selling protection would increase exposure.
- ABuying protection through a single-name credit default swap on the borrowerCorrect
- BSelling protection through a single-name credit default swap on the borrower
- CEntering a total return swap as the total return payer in reverse, receiving the loan's return
- DBuying a call option on the bank's own equity
Explanation
Buying CDS protection pays the bank upon a credit event on the reference entity, transferring default risk without selling the loan. Selling protection would add exposure to the same name and double the risk. Receiving the total return would also add credit exposure, and an equity call does not hedge the loan.
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