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

A bank holds a portfolio with expected loss of USD 25 million. Its 99.9% credit VaR (percentile loss) is USD 205 million. Management sets economic capital at the unexpected loss at that confidence level. Later, the analyst raises the average asset correlation in the model while keeping each obligor's default probability and exposure unchanged. Which outcome is most likely?

Expected loss stays the same because it depends only on default probability, loss given default and exposure. Higher correlation makes defaults cluster, fattening the tail, so the 99.9% percentile loss and the economic capital above expected loss increase.

  1. AExpected loss rises and the 99.9% percentile loss falls
  2. BExpected loss is unchanged, and the 99.9% percentile loss and economic capital riseCorrect
  3. CExpected loss falls and economic capital is unchanged
  4. DBoth expected loss and economic capital are unchanged

Explanation

Expected loss is the sum of PD x LGD x EAD and does not depend on correlation. Higher correlation clusters defaults, fattening the right tail, so the high percentile loss and unexpected loss rise. The baseline economic capital is 205 - 25 = 180 million and would increase.

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