Skip to content

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

A risk manager runs CreditMetrics on a two-bond portfolio. Each bond has a one-year default probability of 2% and the asset correlation is raised from 0.1 to 0.5, with all other inputs unchanged. Which outcome is most likely for the portfolio's credit loss distribution?

Expected loss stays the same while the tail loss at high confidence increases. Expected loss depends only on individual default probabilities and loss severities, but higher asset correlation raises the chance of joint defaults, which fattens the tail and increases unexpected loss.

  1. AExpected loss rises materially, while tail loss is unchanged
  2. BExpected loss is unchanged, while the tail loss at high confidence levels increasesCorrect
  3. CExpected loss falls and the tail loss falls because diversification improves
  4. DBoth expected loss and unexpected loss are unchanged because default probabilities are unchanged

Explanation

Expected loss is the sum of individual expected losses, which depend on default probability and loss given default, not correlation. Higher asset correlation raises joint default probability, fattening the tail and raising unexpected loss and credit VaR. The 'unchanged' option wrongly assumes correlation does not affect dispersion.

Did you get it right without looking?

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

Practise Portfolio Credit RiskFree diagnostic mock

More Portfolio Credit Risk questions