FRM Part II · FRM Exam Part II · Derivatives
An investor buys a five-year credit-linked note (CLN) issued by a bank, linked to a reference entity, with a principal of USD 5 million. The reference entity defaults with recovery of 40% of par. Ignoring coupons and issuer default, how much principal does the investor receive?
The investor receives USD 2 million. A credit-linked note embeds sold protection, so on the reference entity's default the principal repaid is reduced to the recovery value, 40% of USD 5 million.
- AUSD 2 millionCorrect
- BUSD 3 million
- CUSD 5 million
- DUSD 0
Explanation
A CLN embeds a CDS sold by the investor. On a credit event the principal is reduced by the loss: 5 × 40% recovery = USD 2 million is repaid. Option B is the loss amount (60%). Option C ignores the credit event.
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