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FRM Part I · FRM Exam Part I · Trading Strategies

An investor holds a 5-year principal-protected note issued by a bank, with the principal guaranteed at maturity by the issuer. Which statement about the protection is correct?

The protection depends on the issuer's creditworthiness. A principal-protected note is an unsecured obligation of the issuing bank, so if the issuer defaults the investor can lose principal. The guarantee also applies only at maturity, not to resale values before then.

  1. AThe protection is only as reliable as the issuer's creditworthiness, so the investor retains exposure to issuer credit riskCorrect
  2. BThe protection removes all risk because the principal is guaranteed by the index's performance
  3. CThe principal is guaranteed by the exchange clearing house, so issuer default does not matter
  4. DThe principal is protected in full if the note is sold in the secondary market before maturity

Explanation

Principal protection is an obligation of the issuer, so if the issuer defaults the investor may lose principal. The protection applies at maturity only; the market value before maturity can fall below par. The index does not guarantee principal and clearing houses are not involved in these notes.

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