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FRM Part II · FRM Exam Part II · Credit Risk Management

A portfolio has two loans, each with exposure of 10 million, loss given default of 60% and one-year default probability of 2%. Treating default events as independent, what is the portfolio expected loss, and how does it change if default correlation rises to 0.5?

Expected loss is 0.24 million, from 0.12 million per loan (10 million x 2% x 60%), and it is unchanged by correlation because expected loss is additive. Correlation affects the volatility and tail of losses, not their average.

  1. A0.24 million; it rises with correlation
  2. B0.24 million; it is unchanged by correlationCorrect
  3. C0.12 million; it is unchanged by correlation
  4. D0.48 million; it falls with correlation

Explanation

Each loan EL = 10 x 0.02 x 0.6 = 0.12 million, so the total is 0.24 million. Expected loss is linear in individual loan expected losses, so correlation does not affect it. Correlation changes unexpected loss and tail risk, not the mean. The 0.12 option counts only one loan.

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