Credit Risk Management Practice Exam

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For a two-asset portfolio, how is the risk contribution of the first asset calculated?

RC1 = UL1 × (UL2 + ρ12 × UL1) / ULP
RC1 = UL1 + (UL1 + ρ12) / ULP
RC1 = UL1 × (UL1 + ρ12 × UL2) / ULP
RC1 = UL1 + ρ12 × UL2 / ULP

The correct answer is: RC1 = UL1 × (UL1 + ρ12 × UL2) / ULP

The risk contribution of the first asset in a two-asset portfolio is a measure of how much that asset contributes to the overall risk of the portfolio. To calculate this, it is essential to consider not only the asset's own risk but also how it interacts with the other asset in the portfolio. The formula indicates that the risk contribution is derived by multiplying the unique risk (UL1) of the first asset by a factor that accounts for the risk contribution of the second asset and their correlation. Specifically, it incorporates the unique risk of the first asset, the unique risk of the second asset (UL2), and the correlation (ρ12) between the two assets. This reflects the idea that the risk of one asset does not operate in isolation but influences and is influenced by the risk of other assets in the portfolio. Furthermore, the calculated result is divided by the total portfolio risk (ULP) to express the contribution of the first asset in proportion to the total risk level of the portfolio, thus providing a relative measure of its influence. Understanding this calculation framework is vital for effective risk management within a portfolio, as it allows investors and analysts to identify the extent to which each asset contributes to the overall risk, informing better investment decisions and risk mitigation strategies.