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

A risk manager compares two portfolios with identical expected loss. Portfolio X has higher default correlation among its obligors than Portfolio Y. Which statement about their loss distributions is most accurate?

Portfolio X has the fatter right tail and higher credit VaR. Expected loss is unaffected by correlation, but higher default correlation makes defaults cluster, increasing loss variance and the probability of extreme losses, so unexpected loss and tail measures are larger even with identical expected loss.

  1. APortfolio X has a fatter right tail, so higher credit VaR and unexpected lossCorrect
  2. BPortfolio X has a lower credit VaR because expected loss is the same
  3. CBoth portfolios have the same unexpected loss because expected loss is equal
  4. DPortfolio Y has the fatter right tail because diversification raises tail losses

Explanation

Expected loss does not depend on correlation, but the variance and tail of the loss distribution do. Higher default correlation makes defaults cluster, raising the probability of extreme losses and so unexpected loss and credit VaR. Equal expected loss therefore does not imply equal risk.

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