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FRM Part I · FRM Exam Part I · Trading Strategies

An investor holds a bank-issued principal-protected note and is told the principal is fully guaranteed at maturity. Which statement best describes the risk that the guarantee faces?

The guarantee is only as strong as the issuer's credit. A principal-protected note is an unsecured claim on the issuing bank, so if the issuer defaults the investor can lose principal despite the structure of a zero-coupon bond plus option.

  1. AThe protection depends on the issuer's creditworthiness, so issuer default can cause a loss of principalCorrect
  2. BThe protection is backed by the index options, so it fails only if the index falls below its starting level
  3. CThe protection is risk-free because the note contains a zero-coupon bond
  4. DThe protection applies only if the investor sells the note before maturity

Explanation

Such a note is an unsecured obligation of the issuer. The embedded zero-coupon bond and option are claims on the issuer, so if the issuer defaults the investor may lose part of the principal. The index level does not determine whether the protection is honored.

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