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

A validator reviews a Gaussian copula-based credit portfolio model that uses a single constant asset correlation of 0.15 for all obligors. Which limitation is most directly relevant to the accuracy of its tail loss estimates in a stressed period?

Constant correlation combined with the Gaussian copula's lack of tail dependence can understate joint defaults in a crisis, when correlations typically rise. This leads to underestimated tail losses and credit VaR in stressed conditions.

  1. AGaussian copulas have too much upper-tail dependence, overstating losses in all periods
  2. BConstant correlation and the Gaussian copula's lack of tail dependence can understate the likelihood of joint defaults in a crisisCorrect
  3. CThe model cannot produce a loss distribution because copulas need normal marginal default probabilities
  4. DCorrelation is irrelevant because credit VaR depends only on average PD

Explanation

The Gaussian copula has no tail dependence, and a fixed correlation ignores that correlations rise in downturns. Both features make simultaneous defaults in stress more likely than the model implies. The claim of excessive tail dependence is the reverse of the truth.

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