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FRM Part II · FRM Exam Part II · Portfolio Credit Risk

A bank holds a USD 50 million loan to Corvane Ltd with an expected loss rate of 2% and buys CDS protection on USD 30 million notional of that loan. Assume the CDS pays notional times (1 - recovery) on default, the recovery rate is 40%, and the protection seller is default-free. For a Corvane default, what is the bank's loss on the loan net of the CDS payout?

The net loss is USD 12 million. The unhedged loss is 50 million times 60% loss given default, or 30 million. The CDS pays 30 million times 60%, or 18 million. Subtracting leaves 12 million, assuming the protection seller does not default.

  1. AUSD 12.0 millionCorrect
  2. BUSD 18.0 million
  3. CUSD 30.0 million
  4. DUSD 2.0 million

Explanation

Loss on the loan = 50 x (1 - 0.40) = USD 30 million. CDS payout = 30 x 0.60 = USD 18 million. Net loss = 30 - 18 = USD 12 million. USD 18 million is just the payout; USD 30 million ignores the hedge; USD 2 million misuses the expected loss rate.

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