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FRM Part II · FRM Exam Part II · Credit Risk Management

A bank holds a USD 50 million loan to Corporate A and buys single-name credit default swap protection on the same loan from a highly rated dealer. Which risk does the bank mainly retain after the hedge?

The bank mainly retains counterparty risk. The CDS moves Corporate A's default loss to the protection seller, but if the seller cannot perform when default occurs, the bank is left unprotected. The other listed risks are not what the hedge primarily leaves.

  1. ACounterparty risk that the protection seller fails to pay when Corporate A defaultsCorrect
  2. BInterest rate risk from the loan's coupon being converted to a fixed payment
  3. CRisk of the loan being prepaid by the borrower at par
  4. DEquity market risk from changes in Corporate A's share price

Explanation

A CDS transfers the reference entity's credit loss to the protection seller, but the buyer becomes exposed to the seller's ability to pay. Interest rate risk and prepayment are not addressed by the CDS in the way the distractors describe, and equity risk is not the main residual risk.

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