Credit risk from OTC dealer - 2018 AM Mock Q38

CFA Level III Derivatives
#1

Hi guys - Confused with this question re the Apollo Bank Case Scenario.

Item says investment portfolio includes large and small cap domestic stocks and global bonds. Bonds denominated in various currencies and have fixed and floating rates. Fund uses OTC derivatives to hedge risks related to interest rates, FX, adverse security price movements, and payment default.

Q: portfolio most likely has greatest net exposure to which source of risk?

A) Credit Risk

B) Market Risk

C) Liquidity Risk

Answer is liquidity risk because of small caps. I get the point but it seems obscure. I thought hedging all of your positions with OTC derivatives would expose you to the default risk of the swaps dealer, i.e. counterparty credit risk?

From CFAI p143:

“Until the era of over-the-counter derivatives, credit risk was more or less exclusively a concern in the bond and loan markets. Exchange-traded derivatives are guaranteed against credit loss. OTC derivatives, however, contain no explicit credit guaranty and, therefore, subject participants to the threat of loss if their counterparty fails to pay.”

Thanks

#2

Fell to that one too as I had the same thought process as you. I’d like some classification as well. So many inconsistencies in this levels material.

#3

Full disclosure, I think I got this one wrong when I was doing it; a lot of the questions on that mock I found were worded a bit obscurely… but alas:

I don’t think by “credit risk” as an answer choice they meant “counterparty credit risk” (OTC) I assume they were referring to the credit risk from bond issuers, which later in the paragraph it says they hedged out of. By also hedging out adverse security price movements (market risk I guess they were getting at) that only leaves 1 possible answer. Again, I also got this wrong on my first go so take this comment at face value…