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FRM Part II · FRM Exam Part II · Credit Risk

In a one-factor Vasicek-type (Gaussian copula) portfolio model with a large homogeneous portfolio, the asset correlation among borrowers is increased while the unconditional default probability is unchanged. What is the effect on the portfolio loss distribution?

Expected loss stays the same, but the loss distribution gets a fatter right tail, so credit VaR rises. Higher asset correlation increases the weight of the systematic factor, which cannot be diversified away even in a large portfolio.

  1. AExpected loss rises and the tail becomes thinner
  2. BExpected loss is unchanged and the tail becomes fatter, raising credit VaRCorrect
  3. CExpected loss falls and credit VaR falls
  4. DExpected loss and credit VaR are both unchanged because diversification is complete

Explanation

Expected loss depends on PD, EXPOSURE and LGD, not correlation. Higher correlation increases the dependence of defaults on the common factor, so the distribution becomes more skewed with a fatter right tail, increasing high-quantile loss. Idiosyncratic risk diversifies but systematic risk does not.

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