FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms
A bank wants to reduce credit risk on a loan by transferring both the risk and the legal rights, with the borrower's consent and a new lender replacing the bank in the loan agreement. Which mechanism is described?
The mechanism is novation. The original lender is replaced by a new lender in the loan contract, with the borrower's consent, so both the credit risk and legal rights transfer. A participation, CDS or total return swap leaves the original lender as the contractual party.
- ALoan participation
- BNovationCorrect
- CCredit default swap
- DTotal return swap
Explanation
Novation replaces the original lender with a new party in the contract, extinguishing the original lender's rights and obligations, and requires borrower consent. A participation leaves the original lender in the contract, while swaps are synthetic and do not change the loan contract.
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