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

A bank holds a portfolio of 100 loans of equal size, each with the same standalone default probability. A risk analyst says that adding more borrowers from the same industry and region will reduce portfolio credit risk as much as adding borrowers from unrelated sectors. Which statement best evaluates this claim?

The claim is wrong because diversification depends on default correlation, not just the number of loans. Adding borrowers from the same industry and region that default together reduces risk little, whereas adding less correlated borrowers from other sectors lowers unexpected loss much more.

  1. AIt is incorrect, because diversification benefit is greater when new borrowers have lower default correlation with existing onesCorrect
  2. BIt is correct, because the number of loans alone determines diversification
  3. CIt is incorrect, because diversification increases expected loss in proportion to the number of loans
  4. DIt is correct, because default correlation does not affect unexpected loss

Explanation

Unexpected loss of a portfolio depends on default correlations as well as the number of exposures. Borrowers in the same industry and region tend to default together, so adding them removes little risk. Unrelated sectors lower correlation and reduce unexpected loss more. The claim that count alone matters ignores correlation.

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