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

A bank wants to buy protection on a basket of many small loans but does not want to enter a separate CDS for each name. Which instrument allows it to transfer credit risk on a standardized portfolio of reference entities in a single trade?

A CDS index is the right instrument. It references a standardized basket of entities, so one trade gives protection across the whole portfolio, whereas single-name CDS cover only one entity each and interest rate swaps or Treasury total return swaps do not transfer corporate credit risk.

  1. AA single-name credit default swap
  2. BA credit index such as a CDS indexCorrect
  3. CA plain vanilla interest rate swap
  4. DA total return swap on a Treasury bond

Explanation

A CDS index covers a standardized basket of reference entities, so one trade provides portfolio protection. A single-name CDS covers one entity; interest rate swaps and Treasury total return swaps do not transfer corporate credit risk of the basket.

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