Skip to content

FRM Part II · FRM Exam Part II · Credit Risk Management

A risk manager compares two loan portfolios with identical expected loss. Portfolio X has an average pairwise default correlation of 0.05 and Portfolio Y has 0.25. All else equal, which statement about unexpected loss and the loss distribution is correct?

Portfolio Y has higher unexpected loss and a fatter right tail. Expected loss is unaffected by correlation, but loss variance includes covariance terms that grow with default correlation, so clustered defaults raise tail losses and economic capital needs.

  1. ABoth have the same unexpected loss because expected loss is equal
  2. BPortfolio X has higher unexpected loss because low correlation increases variance
  3. CPortfolio Y has higher unexpected loss and a fatter right tail because higher default correlation increases loss varianceCorrect
  4. DPortfolio Y has lower economic capital because correlation reduces the probability of default

Explanation

Portfolio loss variance rises with default correlation, as covariance terms increase. Expected loss depends only on PD, exposure and LGD, so equal EL does not imply equal UL. Higher correlation gives a fatter right tail and requires more economic capital.

Did you get it right without looking?

One question tells you little. A timed set on Credit Risk Management shows your real accuracy, how long you take and where you lose marks.

Practise Credit Risk ManagementFree diagnostic mock

More Credit Risk Management questions