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

A bank's credit portfolio is concentrated in one industry sector, and the risk team finds that defaults in the sector rise together during downturns. Which action most directly reduces the portfolio's default correlation and tail loss?

Diversifying across sectors and regions with different sensitivity to systematic factors lowers default correlation and therefore tail losses. Adding more loans in the same sector leaves the common factor exposure intact, and changing the confidence level only changes the reported number, not the underlying risk.

  1. AIncreasing the number of loans within the same sector while keeping weights equal
  2. BDiversifying exposures across sectors and regions with lower common-factor sensitivityCorrect
  3. CReplacing floating rate loans with fixed rate loans in the same sector
  4. DLowering the confidence level used for credit VaR

Explanation

Default correlation stems from shared systematic factors. Spreading exposures across sectors and regions with different factor sensitivities lowers correlation and tail loss. More loans in one sector leaves systematic risk. Changing the confidence level only alters the reported measure, not the risk.

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