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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A bank has a USD 80 million exposure to a counterparty, protected by a guarantee that is expected to be honored, from a guarantor whose default is positively correlated with the borrower's default because both operate in the same sector. A risk manager compares this guarantee to one from a guarantor with the same default probability but independent of the borrower. Which statement is correct?

The correlated guarantee gives less effective mitigation. The bank loses only if both borrower and guarantor default, and positive correlation raises that joint probability above the independent case, even though the guarantor's own default probability is unchanged.

  1. AThe correlated guarantee gives less effective mitigation because joint default probability is higherCorrect
  2. BThe correlated guarantee gives more effective mitigation because the guarantor knows the sector
  3. CBoth guarantees give identical mitigation because the guarantor default probability is the same
  4. DThe correlated guarantee eliminates credit risk because both names share the same rating

Explanation

Loss occurs only when both borrower and guarantor default. Positive correlation raises the joint default probability above the product of marginals, which is wrong-way risk in the mitigant. Hence mitigation is weaker even with equal marginal default probabilities.

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