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FRM Part II · FRM Exam Part II · Credit Value at Risk

A bank holds a portfolio whose loans have identical default probabilities. The risk team raises the assumed default correlation among borrowers while keeping each loan's default probability and exposure unchanged. What is the effect on the credit loss distribution?

Expected loss stays the same because it depends only on individual default probabilities, exposures and loss severities. Higher default correlation makes joint defaults more likely, fattening the right tail and increasing the high-percentile loss, so credit VaR rises.

  1. AExpected loss rises and the tail is unchanged
  2. BExpected loss and tail loss both fall because of diversification
  3. CExpected loss is unchanged but the tail becomes fatter, raising credit VaRCorrect
  4. DExpected loss falls and the tail becomes fatter

Explanation

Expected loss is a sum of individual expected losses and does not depend on correlation. Higher correlation increases the probability of many simultaneous defaults, fattening the right tail and raising the high percentile and credit VaR. Diversification benefit shrinks.

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