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

A risk analyst at a bank models the joint default behavior of 100 corporate borrowers using a one-factor Gaussian copula. Each borrower's marginal default probability is taken from its own credit curve. What is the primary role of the copula in this setup?

The copula joins the separately estimated marginal default distributions into a joint distribution by imposing a dependence structure. The marginals come from individual credit curves, so the copula does not determine marginal probabilities, recovery rates, or the measure used.

  1. AIt determines each borrower's individual marginal default probability
  2. BIt links the individual marginal distributions into a joint distribution using a specified dependence structureCorrect
  3. CIt estimates the recovery rate for each borrower
  4. DIt converts risk-neutral default probabilities into real-world probabilities

Explanation

A copula separates the marginal distributions from the dependence structure. The marginals come from each borrower's credit curve, and the copula combines them into a joint distribution. It does not set marginals, recoveries, or change the probability measure.

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