Skip to content

FRM Part II · FRM Exam Part II · Correlation Basics: Definitions, Applications, and Terminology

In a Gaussian copula model of default for a credit portfolio, a risk manager raises the pairwise default correlation from 0.10 to 0.50 while keeping each name's default probability unchanged. What is the most likely effect on the portfolio loss distribution?

Expected loss stays unchanged because it depends only on individual default probabilities and loss severities, but higher default correlation clusters defaults, producing a fatter right tail and larger unexpected loss and high-percentile credit losses.

  1. AExpected loss rises and tail risk falls
  2. BExpected loss is unchanged and the tail becomes fatterCorrect
  3. CExpected loss falls and tail risk rises
  4. DBoth expected loss and tail risk are unchanged

Explanation

Expected loss depends on individual default probabilities, loss given default and exposures, not on correlation. Higher correlation increases the chance of many simultaneous defaults, fattening the tail of the loss distribution and raising unexpected loss and high-percentile measures.

Did you get it right without looking?

One question tells you little. A timed set on Correlation Basics: Definitions, Applications, and Terminology shows your real accuracy, how long you take and where you lose marks.

Practise Correlation Basics: Definitions, Applications, and TerminologyFree diagnostic mock

More Correlation Basics: Definitions, Applications, and Terminology questions