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

A portfolio manager compares two loans with identical expected loss. Loan A has a marginal contribution to portfolio unexpected loss that is much higher than Loan B because Loan A is highly correlated with the rest of the portfolio. Which conclusion is most consistent with sound portfolio management?

Loan A should receive more economic capital and earn a higher spread. Capital should follow each loan's contribution to portfolio unexpected loss, which rises with correlation to the rest of the portfolio, so equal expected losses do not justify equal capital or pricing.

  1. ALoan A should receive less economic capital because its expected loss equals Loan B's
  2. BLoan A should be allocated more economic capital and required to earn a higher spread than Loan BCorrect
  3. CBoth loans should be priced identically since expected losses are equal
  4. DLoan B should be sold first because it diversifies the portfolio

Explanation

Capital allocation should reflect risk contribution, which depends on correlation with the portfolio, not only stand-alone expected loss. Loan A adds more unexpected loss, so it needs more capital and a higher return to meet the hurdle. Loan B diversifies and is the more attractive holding.

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