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

A portfolio has two loans, each with exposure of USD 100 and a one-year PD of 4% and LGD of 50%. Assuming the PD and LGD are known constants, which statement about the portfolio's expected and unexpected loss is correct?

Each loan has expected loss of USD 2 (4% × 50% × 100), so the portfolio total is USD 4. Expected loss is additive whatever the default correlation; correlation only affects the volatility of losses, meaning unexpected loss, not the mean.

  1. AExpected loss is USD 4 in total, and it is additive across loans regardless of default correlationCorrect
  2. BExpected loss is USD 2 in total, and it falls as default correlation rises
  3. CExpected loss is USD 4 in total, and it rises as default correlation rises
  4. DExpected loss is USD 2 in total, and it is additive only if correlation is zero

Explanation

Each loan's EL = 0.04 × 0.5 × 100 = USD 2, so the total is USD 4. Expected value is linear, so default correlation does not change EL; it changes unexpected loss (the loss standard deviation), which rises with correlation.

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