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

A bank's credit portfolio is heavily concentrated in a single industry. The risk committee asks which action would most directly reduce the portfolio's unexpected loss without lowering expected return per unit of exposure. Which action is most appropriate?

The best action is to hedge or sell down the concentrated industry exposure and redeploy into sectors with lower default correlation. This reduces the correlated, systematic part of portfolio risk, which is what drives unexpected loss in a concentrated book.

  1. AIncrease exposure limits for the largest obligors in the industry
  2. BPurchase credit protection or sell down exposure in the concentrated industry and redeploy into lower-correlated sectorsCorrect
  3. CRaise the collateral haircut on existing loans only
  4. DShorten tenor of all loans uniformly while keeping sector weights

Explanation

Reducing concentration in a correlated sector lowers systematic exposure to that sector and thus unexpected loss. Raising limits increases concentration, and a uniform tenor cut leaves sector correlation unchanged.

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