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FRM Part II · FRM Exam Part II · Financial Correlation Modeling - Bottom-Up Approaches

A credit portfolio manager uses a one-factor Gaussian copula to model default times of a large homogeneous portfolio of loans. The pairwise asset correlation is increased from 0.20 to 0.50 while each name's marginal default probability is held constant. Which is the most likely effect on the portfolio loss distribution?

Expected portfolio loss stays unchanged because marginal default probabilities are fixed, but higher correlation fattens the tails of the loss distribution. Extreme joint-default scenarios become more likely, which raises the risk of senior tranches.

  1. AExpected portfolio loss rises and the distribution becomes less skewed
  2. BExpected portfolio loss is unchanged, but the tails become fatter, raising the probability of extreme losses and the senior tranche riskCorrect
  3. CExpected portfolio loss falls because diversification increases
  4. DExpected portfolio loss is unchanged and the probability of extreme losses falls

Explanation

Expected loss depends only on the marginal default probabilities and loss given default, so it stays the same. Higher correlation raises the probability of many simultaneous defaults and also of very few defaults, fattening the tails and increasing senior tranche risk while lowering equity tranche risk.

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