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FRM Part I · FRM Exam Part I · Trading Strategies

Which statement about the credit exposure of an investor in a principal-protected note is correct?

The investor bears the issuer's default risk. Principal protection is only a promise by the issuing institution, so if the issuer fails, the note's principal repayment and option payoff may not be paid, whatever the performance of the underlying index.

  1. AThe principal protection is a guarantee from the exchange on which the option component trades
  2. BThe protection depends on the issuer's creditworthiness, so the investor bears the issuer's default riskCorrect
  3. CThe protection removes all risk because the zero-coupon component always matures at face value
  4. DThe investor bears no credit risk if the option component is out of the money at maturity

Explanation

A principal-protected note is an obligation of the issuer, so the promised return of principal is only as good as the issuer's ability to pay. The bond component does not remove default risk, and exchange guarantees do not apply to a note issued by a bank. Option moneyness affects the payoff size, not the issuer's credit risk.

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