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

An investor buys a credit-linked note (CLN) with a face value of USD 10 million from a bank. The note pays a coupon and is linked to the credit of a reference entity. If the reference entity defaults, which outcome applies to the investor?

The investor's redemption is reduced by the loss on the reference entity, so it receives a recovery-based amount instead of par. A credit-linked note is funded, with the investor having effectively sold protection. The loss is capped at the principal invested, so no extra payment is owed.

  1. AThe investor must pay the bank the difference between par and the recovery value in addition to losing the principal
  2. BThe investor receives par value because the bank guarantees redemption
  3. CThe investor's principal is reduced by the loss on the reference entity, so it receives recovery-based value rather than parCorrect
  4. DThe note converts into a CDS with the investor as protection buyer

Explanation

A CLN is a funded structure: the investor pays the principal up front and effectively sells credit protection. On a credit event the redemption is reduced by the loss on the reference obligation. The investor's loss is limited to the principal invested, so it does not owe additional payments.

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