FRM Part II · FRM Exam Part II · Credit Risk
A bank holds a USD 50 million loan to a corporate borrower and wants to remove the credit risk of default while keeping the loan on its books and retaining the relationship with the borrower. It pays a periodic fee to a protection seller who will compensate it for loss if the borrower defaults. Which instrument is described?
A credit default swap referencing the borrower fits. The bank pays a periodic premium and receives compensation if a credit event occurs, transferring default risk while keeping the loan and the client relationship. The other instruments hedge equity or interest rate risk, or transfer the asset itself.
- AA total return swap on the borrower's equity
- BA credit default swap referencing the borrowerCorrect
- CAn interest rate swap paying fixed and receiving floating
- DA cash collateralized debt obligation of the loan
Explanation
A CDS lets the buyer pay a periodic premium in return for a contingent payment on a credit event, so the loan stays on the balance sheet while default risk is transferred. An equity total return swap does not hedge loan default, an interest rate swap hedges rate risk, and a cash CDO would move the loan off the books, ending the retained exposure.
Did you get it right without looking?
One question tells you little. A timed set on Credit Risk shows your real accuracy, how long you take and where you lose marks.
More Credit Risk questions
- A risk manager notes that short-term credit spreads for investment-grade issuers in Merton-type models are typically close to zero, yet obse…
- An investor buys five-year protection on a reference entity with a CDS notional of USD 20 million at a spread of 150 basis points per year, …
- 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…
- A credit analyst compares two approaches to modeling a corporate borrower's default. Model A treats the firm's equity as a call option on it…
- A bank's retail risk team builds a scorecard and wants a single statistic that shows how well the score separates defaulters from non-defaul…
- A bank's credit portfolio has a one-year expected loss of USD 40 million. The 99.9% one-year credit VaR, measured as the worst-case loss qua…