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FRM Part II · FRM Exam Part II · Financial Correlation Modeling - Bottom-Up Approaches

Which of the following correlation types is generally the most relevant for measuring how defaults of different obligors cluster together in a credit portfolio?

Default correlation between obligors is the relevant measure because it captures how likely borrowers are to default together, which determines clustering of defaults and the fatness of the portfolio loss tail. Autocorrelation, rate-inflation correlation and volume-price correlation do not describe joint default behavior.

  1. ADefault correlation between obligorsCorrect
  2. BAutocorrelation of a single stock's returns
  3. CCorrelation between interest rates and inflation only
  4. DCorrelation between trading volume and price

Explanation

Default correlation measures the tendency of obligors to default together, which drives the tail of the portfolio loss distribution. The other options relate to different variables and do not describe joint default behavior.

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