Credit Risk Management Practice Exam

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What does a high correlation between defaults suggest about a credit portfolio?

It indicates greater diversification
It implies an increased risk of simultaneous defaults
It shows that individual credit risk is uniformly low
It refers to only the past performance of the portfolio

The correct answer is: It implies an increased risk of simultaneous defaults

A high correlation between defaults in a credit portfolio suggests that the assets within the portfolio are likely influenced by similar factors or conditions. This means that if one asset experiences default, others are more likely to follow suit, indicating a systemic risk that affects multiple assets simultaneously. In a diversified credit portfolio, you would expect the defaults to be uncorrelated or negatively correlated; hence, a high correlation increases the risk of simultaneous defaults. This could occur due to economic downturns, sector-specific issues, or other factors that simultaneously impact multiple borrowers. Understanding this relationship is crucial for risk management, as it highlights the importance of diversifying credit exposures across different sectors or geographic regions to mitigate the risk of correlated defaults. Recognizing this dynamic helps credit risk managers make more informed decisions to protect the portfolio from systemic shocks.