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FRM Part II · FRM Exam Part II · Portfolio Credit Risk

A bank estimates default correlation from historical joint default frequencies of rating cohorts, and finds estimates unstable. Which practical reason best explains why default correlations are hard to estimate directly?

Direct estimation is unreliable because joint defaults are rare, particularly among high-quality obligors, so observed joint default frequencies are based on very few events and are noisy. Practitioners therefore often infer correlation indirectly from equity or asset returns or factor models.

  1. ADefaults are frequent events, producing too much data
  2. BJoint defaults are rare, so there is little data to estimate joint default probabilities reliablyCorrect
  3. CDefault correlation is always zero for investment-grade obligors
  4. DDefault correlation cannot be positive under any copula

Explanation

Joint defaults are rare events, especially for high-quality names, so sample joint default frequencies are noisy. Analysts therefore often infer correlation from asset or equity returns or from a factor model. The other options are factually wrong.

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