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FRM Part II · FRM Exam Part II · The Global Drivers of Private Credit

A risk manager argues that a prolonged higher-for-longer policy rate environment poses a particular risk to private credit portfolios dominated by floating-rate loans to leveraged borrowers. Which statement best describes the main transmission channel?

Higher base rates lift floating coupons, which raises borrowers' interest burdens and weakens coverage, so interest rate risk turns into credit risk through higher defaults. Lender income rises mechanically, but credit losses can offset this, especially for highly leveraged borrowers.

  1. AHigher base rates raise borrowers' debt service burdens, which can increase defaults even though lenders' coupon income risesCorrect
  2. BHigher base rates reduce lenders' coupon income, lowering returns without affecting borrowers
  3. CHigher base rates cause the fair value of floating-rate loans to rise sharply because of duration
  4. DHigher base rates eliminate credit risk because coupons reset immediately

Explanation

Floating coupons reset upward, shifting interest rate risk from lender to borrower and converting it into credit risk. Option B has the direction of coupon income wrong. Floating loans have low duration, so C is wrong, and D is false.

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