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FRM Part I · FRM Exam Part I · Measuring Credit Risk

A risk manager raises the assumed default correlation among the obligors in a loan portfolio, leaving every obligor's default probability, exposure and loss given default unchanged. Which outcome is correct?

Expected loss stays the same, while loss volatility and credit VaR increase. Expected loss is just the sum of individual expected losses, independent of correlation. Higher default correlation makes defaults cluster, widening the loss distribution and fattening its right tail, which raises the tail loss measured by credit VaR.

  1. AExpected loss is unchanged, but loss volatility and the tail credit VaR increaseCorrect
  2. BExpected loss falls because defaults become more predictable, and credit VaR falls
  3. CExpected loss rises in proportion to correlation, with credit VaR unchanged
  4. DExpected loss and loss volatility are unchanged, but credit VaR falls

Explanation

Expected portfolio loss is the sum of individual expected losses and does not depend on correlation. Higher default correlation raises the covariance terms, increasing loss standard deviation and fattening the right tail of the loss distribution, so credit VaR rises. The other options wrongly link correlation to expected loss or imply a lower tail loss.

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