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

A risk manager notes that the Vasicek large homogeneous portfolio approximation assumes the number of equally weighted obligors tends to infinity. Adding further obligors with the same PD and correlation to a portfolio that already meets this assumption would mainly:

Adding more obligors changes little because the large homogeneous portfolio already assumes idiosyncratic risk has fully diversified. What remains is systematic factor risk, which diversification cannot remove, so the loss distribution and worst-case loss stay essentially the same.

  1. ALeave the loss distribution essentially unchanged, since only systematic factor risk remainsCorrect
  2. BEliminate the systematic risk, bringing the worst-case loss down to expected loss
  3. CReduce the PD of each obligor through diversification
  4. DRaise the asset correlation, because obligors share the same factor

Explanation

In the LHP limit, idiosyncratic risk has already diversified away, and the portfolio loss rate equals the conditional PD given the systematic factor. More obligors cannot remove the common factor risk, so the worst-case loss stays above expected loss. PD and correlation are inputs, not outputs of diversification.

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