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FRM Part II · FRM Exam Part II · Credit Value at Risk

A risk analyst at a bank is explaining why the credit loss distribution of a large loan portfolio is typically skewed to the right with a fat tail. Which factor best explains the fat tail?

Positive default correlation explains the fat tail. Because borrowers share systematic factors such as the business cycle, defaults cluster in downturns, which raises the chance of very large portfolio losses even when the average default probability is low.

  1. APositive default correlation among borrowers causing defaults to cluster in adverse economic conditionsCorrect
  2. BConstant recovery rates across all loans
  3. CLow average probability of default across the portfolio
  4. DUse of fixed-rate rather than floating-rate loans

Explanation

Positive default correlation, often driven by common systematic factors such as the economic cycle, makes many defaults occur together. This raises the probability of extreme losses and thickens the tail. Low average default probability affects the mean loss, not the clustering that creates the tail.

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