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

A bank uses a one-factor Gaussian copula credit VaR model with a constant asset correlation. During validation, the team reruns the model with the correlation raised from 0.10 to 0.25 while keeping all PDs and LGDs unchanged. Which outcome is expected?

Raising asset correlation leaves expected loss unchanged, since it depends only on PD, LGD and exposure, but it increases the 99.9% credit VaR. Higher correlation makes defaults cluster, thickening the tail of the loss distribution and increasing unexpected loss.

  1. AExpected loss is unchanged, while the 99.9% credit VaR risesCorrect
  2. BExpected loss rises and the 99.9% VaR is unchanged
  3. CBoth expected loss and VaR fall because diversification improves
  4. DExpected loss falls and VaR rises by the same amount

Explanation

Expected loss is the sum of PD x LGD x exposure and does not depend on correlation. Higher correlation fattens the tail of the loss distribution, because defaults cluster, so the 99.9% quantile and unexpected loss increase. The distractors confuse the effect on the mean with the effect on the tail.

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