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

A bank wants to measure how much a new USD 20 million loan to a cyclical manufacturer would add to the portfolio's unexpected loss. Stand-alone unexpected loss of the loan is USD 1.5 million. Which approach most accurately captures its contribution to portfolio risk?

The loan's risk contribution is the right measure. It reflects the loan's covariance with the existing portfolio relative to portfolio unexpected loss, so it captures size, volatility and correlation. Stand-alone unexpected loss overstates or misstates the marginal impact because it ignores diversification.

  1. AUse the loan's stand-alone unexpected loss, since it is independent of the other loans
  2. BUse the loan's expected loss, since unexpected loss is not additive
  3. CUse the loan's risk contribution, which is its marginal covariance with the portfolio divided by portfolio unexpected lossCorrect
  4. DDivide the portfolio unexpected loss equally by the number of loans

Explanation

Contribution to portfolio UL accounts for the loan's correlation with the rest of the book: UL_i x correlation with portfolio. Stand-alone UL ignores diversification, and equal division ignores size and correlation.

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