Credit Risk Management Practice Exam

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Regarding granularity in credit portfolios, what occurs if the default probability is low?

The Credit VaR is significantly reduced
The impact of granularity is minimal
The Credit VaR remains unchanged
The risk of default increases substantially

The correct answer is: The impact of granularity is minimal

When the default probability in a credit portfolio is low, the impact of granularity is minimal. Granularity refers to the level of diversification within a portfolio, where a more granular portfolio consists of a higher number of distinct exposures spread across various borrowers or credits. In the scenario of low default probability, the likelihood of any single borrower defaulting is limited, which reduces the overall risk to the portfolio. As a result, introducing additional exposures or diversifying further has a less significant effect on the risk profile. This is because the contribution of diversifying across low-risk assets does not significantly change the overall expected loss or the distribution of potential outcomes. The protection offered through diversification is less impactful when defaults are already unlikely, affirming that granularity's effect diminishes under these conditions. Overall, given a low default probability, the perception of risk remains stable, and the necessity for detailed diversification becomes less pronounced, reinforcing the notion that the impact of granularity is minimal.