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

In a Credit Suisse CreditRisk+ style model, a portfolio has obligors that are conditionally independent given the sector default rate. A risk manager increases the volatility of the gamma-distributed sector default rate while keeping the mean default rate unchanged. What is the most likely effect?

Expected loss stays the same because the mean default rate is unchanged, but the loss distribution develops a fatter right tail. Greater volatility of the common default-rate factor increases default correlation, raising unexpected loss and credit VaR at high confidence levels.

  1. AExpected loss rises and the tail is unchanged
  2. BExpected loss is unchanged but the loss distribution gets a fatter right tail, raising unexpected loss and credit VaRCorrect
  3. CExpected loss falls because defaults become more diversified
  4. DBoth expected loss and the tail fall because the Poisson variance falls

Explanation

Expected loss depends on the mean default rate, which is unchanged. Higher default-rate volatility induces default correlation among obligors in the sector, increasing the variance and skew of portfolio losses and so the high-percentile loss.

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