Module: | MODULE B: RISK MANAGEMENT
Q402: Consider the following statements differentiating Total Return Swaps and Credit Linked Notes within the credit derivatives framework:
1. A Total Return Swap effectively transfers both the credit risk and the market risk of the underlying reference asset to the protection seller.
2. A Credit Linked Note is an unfunded credit derivative that does not require any upfront capital investment by the protection seller.
3. In a typical Credit Linked Note structure, the investor receives a higher coupon rate but bears the risk of losing the principal if a predefined credit event occurs.
Which of the statements given above is/are correct?
2. A Credit Linked Note is an unfunded credit derivative that does not require any upfront capital investment by the protection seller.
3. In a typical Credit Linked Note structure, the investor receives a higher coupon rate but bears the risk of losing the principal if a predefined credit event occurs.
Which of the statements given above is/are correct?
✅ Correct Answer: B
The correct answer is B. Statement 1 is correct: A Total Return Swap (TRS) is a comprehensive derivative.
Unlike a CDS which only transfers credit risk, a TRS transfers BOTH the credit risk (default) and the market risk (price volatility and interest rate fluctuations) of the reference asset to the Total Return Receiver (Protection Seller). Statement 3 is correct: A Credit Linked Note (CLN) is essentially a regular bond with an embedded CDS.
The investor buys the note, earning a higher-than-average coupon rate for taking on credit risk.
If the reference entity defaults, the investor loses their principal, which is used to cover the issuer's losses.
Statement 2 is incorrect: A CLN is strictly a FUNDED credit derivative.
The protection seller (the investor) must make a massive upfront capital investment to purchase the note.
This contrasts with an unfunded derivative like a standard CDS, where no principal changes hands upfront, only periodic premium payments.
Unlike a CDS which only transfers credit risk, a TRS transfers BOTH the credit risk (default) and the market risk (price volatility and interest rate fluctuations) of the reference asset to the Total Return Receiver (Protection Seller). Statement 3 is correct: A Credit Linked Note (CLN) is essentially a regular bond with an embedded CDS.
The investor buys the note, earning a higher-than-average coupon rate for taking on credit risk.
If the reference entity defaults, the investor loses their principal, which is used to cover the issuer's losses.
Statement 2 is incorrect: A CLN is strictly a FUNDED credit derivative.
The protection seller (the investor) must make a massive upfront capital investment to purchase the note.
This contrasts with an unfunded derivative like a standard CDS, where no principal changes hands upfront, only periodic premium payments.