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

Which change would most likely increase the portfolio credit loss at a given high confidence level, holding each loan's PD, LGD and exposure constant?

Raising pairwise default correlation increases high-confidence portfolio loss, because defaults cluster and the loss distribution's tail becomes fatter while expected loss stays the same. More obligors under zero correlation or independent defaults would instead reduce tail loss through diversification.

  1. ARaising the pairwise default correlation among obligorsCorrect
  2. BIncreasing the number of obligors while keeping total exposure fixed and correlation unchanged at zero
  3. CReplacing a single-factor structure with fully independent defaults
  4. DReducing the correlation between PD and LGD to zero from a negative value

Explanation

Higher default correlation fattens the right tail of the loss distribution, raising high-confidence loss quantiles while leaving expected loss unchanged. More obligors with zero correlation or independence lowers tail loss. Moving the PD-LGD correlation from negative to zero is not a clear increase in tail loss in this context.

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