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

A credit portfolio manager models joint defaults of 200 obligors using a one-factor Gaussian copula in which every obligor has the same pairwise asset correlation. She raises the asset correlation from 0.10 to 0.40, leaving each obligor's marginal default probability unchanged. Which outcome is most likely?

Expected loss stays the same because it depends only on marginal default probabilities, exposures and LGD. Higher asset correlation increases the chance of clustered defaults, so the loss distribution gets a fatter right tail and higher tail quantiles, even though the average loss is unchanged.

  1. AThe expected portfolio loss rises sharply while the loss distribution becomes more symmetric
  2. BThe expected portfolio loss is unchanged, but the tail of the loss distribution becomes fatterCorrect
  3. CThe expected portfolio loss falls because defaults are more diversified
  4. DThe expected portfolio loss is unchanged and the 99.9% loss quantile falls

Explanation

Expected loss depends only on marginal default probabilities, LGD and exposures, so it does not change. Higher correlation raises the probability of many simultaneous defaults, which fattens the right tail and increases high-quantile losses. The option claiming a lower quantile reverses the effect of correlation.

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