Question

Northridge First National Bank has a portfolio of collateralized debt obligations. Senior management decides to hedge...

Northridge First National Bank has a portfolio of collateralized debt obligations. Senior management decides to hedge their portfolio against loss of principal. To do so, they would:

purchase forward interest rate contracts.

become a counterparty to an interest rate swap.

purchase credit default swaps.

short the assets.

do none of the above.

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Answer #1

Northridge First National Bank has a portfolio of collateralized debt obligations. Senior management decides to hedge their portfolio against loss of principal. To do so, they would purchase credit default swaps.

Therefore correct answer is option: purchase credit default swaps.

Credit default swaps are derivative instruments which work like insurance for collateralized debt obligations and protect it from credit risk or default. The credit risk arises due to creditworthiness of its borrowers and it includes default risk, recovery risk, concentration risk etc. Therefore Northridge First National Bank should purchase credit default swaps to hedge their portfolio against loss of principal.

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