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

Holding PD and confidence level fixed, a risk manager raises the asset correlation parameter in a Vasicek large homogeneous portfolio model from 0.10 to 0.30. What is the expected effect?

The expected default rate stays equal to the PD, while the 99.9% worst-case default rate rises. Higher asset correlation makes defaults cluster when the common factor is adverse, thickening the loss tail without changing the average default rate.

  1. AThe expected default rate rises and the 99.9% worst-case default rate falls
  2. BThe expected default rate is unchanged and the 99.9% worst-case default rate risesCorrect
  3. CBoth the expected default rate and the worst-case default rate rise
  4. DBoth the expected default rate and the worst-case default rate are unchanged

Explanation

The mean default rate in the model equals the PD regardless of correlation. Higher correlation fattens the tail of the loss distribution, because defaults cluster in bad states of the common factor, so the high-percentile default rate increases. Diversification benefit shrinks while the average stays fixed.

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