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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bank holds a USD 50 million loan to Firm X and buys five-year CDS protection on USD 50 million of Firm X's senior bonds, which is a different instrument from the loan, with a spread of 200 bp. Firm X defaults and the bonds trade at 35% of par while the loan later recovers 55%. The CDS is settled in cash by reference to the bond price. What is the bank's net loss on the loan after the CDS payout, ignoring premiums paid and discounting?

This item is flawed and should not be used.

  1. AUSD 0 million
  2. BUSD 5 millionCorrect
  3. CUSD 17.5 million
  4. DUSD 22.5 million

Explanation

The CDS pays 50 x (1 - 0.35) = 32.5 million. The loan loss is 50 x (1 - 0.55) = 22.5 million. The bank is overcompensated by 10 million, so net result is a gain of 10 million, not a loss. Rechecking options: none shows a gain, so the premise needs adjusting: the intended net loss is loan loss minus payout = 22.5 - 32.5 = -10.

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