Credit Risk Management Practice Exam

How does default correlation impact a credit portfolio's Credit VaR?

1. A higher correlation leads to increased Credit VaR

2. A lower correlation decreases the Credit VaR

3. A correlation of 1 results in a non-diversified portfolio

4. All of the above

The correct answer is: All of the above

Default correlation refers to the likelihood that two or more obligors in a credit portfolio will default simultaneously. Understanding this concept is crucial for assessing the overall risk in a credit portfolio. When there is a higher correlation among defaults, it suggests that if one obligor is likely to default, others will likely follow suit. This interconnectedness can amplify potential losses, leading to an increase in Credit Value at Risk (Credit VaR). In other words, the risk associated with the entire portfolio rises, which means that potential losses in the portfolio can be significantly greater than they would be if defaults were more independent. Conversely, when the correlation is lower, the likelihood of simultaneous defaults decreases. This lower correlation indicates that the performance of one obligor is less likely to impact others, which serves to decrease the overall risk of the portfolio. Hence, a lower correlation results in a reduced Credit VaR, reflecting a more diversified portfolio where risks are more spread out. A correlation of 1 indicates perfect correlation among the obligors, meaning that if one defaults, all will default. This scenario leads to a highly undiversified portfolio, as there’s no cushioning effect to mitigate risks from individual defaults. Consequently, the overall risk assessed would be at maximum, translating to heightened