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FRM Part II · FRM Exam Part II · Credit Risk

A risk analyst compares two portfolios with identical expected loss and identical individual obligor default probabilities. Portfolio X has higher pairwise default correlation than Portfolio Y. Which statement about their loss distributions is most accurate?

Portfolio X has a fatter right tail and a higher credit VaR at high confidence levels. Expected loss is unchanged, but greater default correlation increases loss variance and the chance of clustered defaults, pushing out extreme quantiles. Correlation does not create offsets in credit losses the way it can in diversified returns.

  1. APortfolio X has the same credit VaR because expected loss is equal
  2. BPortfolio X has a lower credit VaR because correlated defaults offset each other
  3. CPortfolio X has a fatter right tail and higher credit VaR at high confidence levelsCorrect
  4. DPortfolio X has a lower standard deviation of losses but a higher mean

Explanation

Higher default correlation raises loss variance and skews the distribution, increasing the probability of many simultaneous defaults. The mean is unchanged, but the high-confidence quantile rises. Defaults do not offset each other, since losses only occur on default.

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