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

A bank wants to reduce the expected tail losses of its loan portfolio and considers selling a loan to a high-concentration industry versus buying a basket of CDS. Which portfolio management tool assesses an exposure's contribution to portfolio risk best when deciding which loans to reduce?

Marginal contribution to portfolio credit VaR or economic capital is best. It captures an exposure's size, default risk and correlation with the rest of the portfolio, showing how much portfolio tail risk falls if it is sold or hedged. Stand-alone metrics ignore diversification.

  1. AMarginal (incremental) contribution to portfolio credit VaR or economic capitalCorrect
  2. BThe loan's stand-alone expected loss
  3. CThe loan's coupon rate
  4. DThe borrower's external rating alone

Explanation

Marginal risk contribution reflects both the exposure's size, default probability and correlation with the rest of the portfolio, so it identifies which loans most reduce tail risk if sold or hedged. Stand-alone expected loss, coupon and rating ignore diversification effects.

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