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FRM Part I · FRM Exam Part I · Measuring Credit Risk

Which statement about expected and unexpected credit losses in a loan portfolio is most accurate?

Expected loss adds up linearly across loans, but portfolio unexpected loss depends on default correlations and is normally smaller than the sum of individual unexpected losses when correlations are below one, which is the diversification benefit.

  1. AUnexpected loss is additive across loans regardless of default correlation
  2. BExpected loss is additive across loans, while portfolio unexpected loss depends on correlations and is generally less than the sum of stand-alone unexpected lossesCorrect
  3. CExpected loss falls as default correlation rises, while unexpected loss is unaffected
  4. DUnexpected loss is the mean loss, and expected loss is its standard deviation

Explanation

Expected losses sum linearly across exposures. Standard deviations combine through correlations, so with correlation below one the portfolio figure is below the simple sum. Correlation does not change expected loss, only the spread of losses.

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