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

A bank has a loan portfolio whose obligors become more strongly correlated in default because of increased sector concentration, while each obligor's PD, LGD and EAD are unchanged. Which effect is most likely?

Expected loss is additive and independent of correlation, so it stays the same. Higher default correlation widens the loss distribution and fattens its tail, which raises unexpected loss and the capital needed at a high confidence level.

  1. AExpected loss is unchanged, while unexpected loss and economic capital increaseCorrect
  2. BExpected loss and economic capital are both unchanged
  3. CExpected loss increases, while unexpected loss is unchanged
  4. DExpected loss and unexpected loss both fall because defaults cluster

Explanation

Expected loss is the sum of individual expected losses and does not depend on correlation. Higher default correlation fattens the tail of the loss distribution and raises its standard deviation and high quantiles, so unexpected loss and economic capital rise.

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