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

A risk manager compares two loan portfolios with identical individual default probabilities and identical exposures. Portfolio A has a higher pairwise default correlation than Portfolio B. Which statement best describes the credit loss distributions, assuming expected loss is the same?

Higher default correlation leaves expected loss unchanged but makes defaults cluster, widening the loss distribution and fattening the right tail. Portfolio A therefore has greater unexpected loss and a higher credit VaR than Portfolio B, even though individual default probabilities and exposures are identical.

  1. APortfolio A has the same unexpected loss as B because expected loss is identical
  2. BPortfolio A has a fatter right tail and a higher credit VaR than Portfolio BCorrect
  3. CPortfolio A has a thinner right tail because defaults cluster in few periods
  4. DPortfolio A has lower credit VaR because higher correlation reduces default probability

Explanation

Expected loss depends only on default probabilities, exposures and LGD, so it is unchanged. Higher default correlation makes defaults cluster, raising the variance and fattening the right tail, so credit VaR and unexpected loss rise. Option 0 ignores that unexpected loss depends on correlation.

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