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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A credit portfolio manager compares two portfolios with identical expected loss. Portfolio X is diversified across many obligors and industries. Portfolio Y has the same total exposure but is concentrated in a few large borrowers in one sector. Which statement about credit VaR at a high confidence level is most accurate?

Portfolio Y, which is concentrated in few borrowers in one sector, has higher unexpected loss and credit VaR. Expected loss is the same, but concentration and higher default correlation fatten the right tail of the loss distribution, so more capital is needed.

  1. APortfolio X has the higher unexpected loss because diversification increases default correlation.
  2. BBoth portfolios have equal credit VaR because expected loss is equal.
  3. CPortfolio Y has the higher unexpected loss and credit VaR because concentration and correlation fatten the tail of the loss distribution.Correct
  4. DPortfolio Y has lower credit VaR because large exposures default less often.

Explanation

Expected loss depends only on PD, LGD and EAD, but the tail depends on concentration and default correlation. Portfolio Y's loss distribution is more skewed with a fatter tail, so its unexpected loss and credit VaR are higher. Equal expected loss does not imply equal tail risk.

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