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Answer: CDS quantify the manufacturing company's default risk and allow the bank to monitor changes in this risk on a real-time basis.
The correct answer is A. CDS (credit default swaps) are financial derivatives that allow a bank to transfer the credit risk of a loan to a third party. In this scenario, the bank is concerned about the credit risk of a loan to a large manufacturing company that is losing market share. By using a CDS, the bank can quantify the company's default risk and monitor changes in this risk on a real-time basis. This provides a more dynamic and responsive risk management tool compared to traditional credit ratings, which are updated periodically. The CDS does not require the company to pay back the loan early (option C), nor does it provide an agreement to revalue the loan periodically (option B). Additionally, CDS do not allow the bank to offset its exposure to the company with loan exposures to other companies (option D). Instead, CDS specifically address the credit risk associated with the loan to the manufacturing company.
Author: LeetQuiz Editorial Team
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A risk analyst at a growing financial institution is concerned about the bank's loan exposure to a large manufacturing company that is facing a significant decrease in its market share within its industry. The analyst is considering various credit risk transfer strategies, including the use of credit default swaps (CDS), to manage and mitigate this risk. Which of the following statements correctly identifies an appropriate benefit of using CDS in this situation?
A
CDS quantify the manufacturing company's default risk and allow the bank to monitor changes in this risk on a real-time basis.
B
CDS provide an agreement to periodically revalue the loan and transfer any net value change.
C
CDS require the manufacturing company to pay back the loan in full at an earlier point in time.
D
CDS allow the bank to offset its exposure to the company with loan exposures to other manufacturing companies.
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