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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 to borrowers in the same industry and region. A risk manager proposes adding 100 additional loans of the same size to borrowers in many different industries and regions. Which statement best describes the expected effect on the portfolio's credit risk profile?

Unexpected loss relative to exposure falls, because adding borrowers from different industries and regions lowers average default correlation and reduces loss volatility. Expected loss is unaffected by correlation, and correlation does not fall to zero, so the other statements are wrong.

  1. AExpected loss rate falls because correlation between defaults is reduced to zero
  2. BUnexpected loss as a share of exposure falls because default correlation across the whole portfolio declinesCorrect
  3. CUnexpected loss as a share of exposure rises because of greater name count
  4. DExpected loss as a share of exposure rises because new borrowers are unfamiliar

Explanation

Diversifying across industries and regions lowers the average pairwise default correlation, which reduces portfolio loss volatility (unexpected loss) relative to exposure. Expected loss depends on PD, LGD and exposure of each loan, so it is not driven by correlation. Correlation does not become zero.

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