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

A risk analyst at a bank compares two approaches to modeling joint defaults of a portfolio of corporate borrowers. In the first approach, the analyst specifies each borrower's individual default probability and then links them with a correlation structure. In the second approach, the analyst models the loss distribution of the whole portfolio directly. Which statement correctly describes the first approach?

The first approach is bottom-up. It builds portfolio default behavior from each borrower's own default probability and a correlation or dependence structure, whereas top-down models model aggregate portfolio losses directly without specifying individual entities.

  1. AIt is a top-down approach because it starts from portfolio-level loss data
  2. BIt is a bottom-up approach because it builds portfolio default behavior from individual entity default probabilities and their dependenceCorrect
  3. CIt is a top-down approach because it ignores individual default probabilities
  4. DIt is a bottom-up approach only if all borrowers have identical default probabilities

Explanation

Bottom-up models start with individual entity default probabilities and combine them using a dependence structure, such as a copula, to obtain the portfolio loss distribution. Top-down models work directly with aggregate portfolio losses. Identical default probabilities are not required.

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