Bank A holds a credit risky asset on its balance sheet.It enters into a total return swap (TRS)referenced to this asset with hedge fund B to pay the total return to B and receive Libor in return.Under what scenario does bank A bear credit risk on the reference asset this contract?

Question

Quizplus · Accepted Answer

If the issuer of the reference asset defaults,the loss on the reference asset is borne by B via the TRS.If hedge fund B defaults,no risk is borne on the reference asset as it has not defaulted.Hence,both B and the issuer of the reference asset need to default before bank A bears any risk on the reference asset.

Bank a Holds a Credit Risky Asset on Its Balance