FRM Part I · FRM Exam Part I · Measuring Credit Risk
Which of the following best explains why a loan portfolio's unexpected loss is generally less than the sum of the stand-alone unexpected losses of its loans?
Portfolio unexpected loss is less than the sum of stand-alone figures because default correlations between borrowers are below one. Defaults do not all happen together, so the portfolio's loss volatility benefits from diversification.
- AExpected losses are subtracted from each loan's unexpected loss
- BDefault correlations between borrowers are below one, giving diversification benefitsCorrect
- CLoss given default is always lower in portfolios than for single loans
- DUnexpected loss is calculated only on the largest exposures
Explanation
Portfolio loss variance depends on pairwise default correlations. When correlations are below one, losses do not all occur together, so portfolio standard deviation is below the sum of individual ones. The other options misstate how unexpected loss is calculated.
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