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

A risk analyst uses the Vasicek single-factor model for a large homogeneous loan portfolio. She holds each obligor's PD and LGD fixed and raises the common asset correlation from 0.10 to 0.30. Which outcome is most likely?

Expected loss stays the same because it depends only on PD, LGD and exposure. A higher asset correlation makes defaults cluster around the systematic factor, which fattens the loss tail, so the 99.9% loss quantile rises.

  1. AExpected portfolio loss is unchanged, but the 99.9% loss quantile risesCorrect
  2. BExpected portfolio loss rises, and the 99.9% loss quantile is unchanged
  3. CExpected portfolio loss falls, because defaults become more predictable
  4. DBoth expected loss and the 99.9% loss quantile are unchanged, because PD is fixed

Explanation

Expected loss depends on PD, LGD and exposure, so changing correlation leaves it alone. Higher correlation increases the weight of the systematic factor and fattens the tail of the default-rate distribution. The 99.9% quantile therefore rises.

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