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FRM Part II · FRM Exam Part II · Credit Derivatives

A portfolio manager at a bank wants to hedge broad investment-grade corporate credit exposure quickly and at low transaction cost, without selecting individual reference entities. Which instrument is the most direct fit?

Buying protection on a standardized CDS index is the best fit. It offers liquid, low-cost, diversified protection across many investment-grade issuers in one trade, whereas single-name CDS cover one issuer, and selling protection increases credit exposure instead of hedging it.

  1. ABuying protection on a standardized credit default swap indexCorrect
  2. BBuying a single-name CDS on the largest holding only
  3. CSelling protection on a first-to-default basket
  4. DEntering a total return swap on a government bond

Explanation

A standardized CDS index (such as CDX or iTraxx) gives liquid, diversified credit protection across many names in one trade. A single-name CDS covers only one issuer. Selling protection on a basket adds credit risk rather than hedging it. A government bond total return swap does not hedge corporate credit.

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