Credit Risk Management Practice Exam

What effect does portfolio granularity have on Credit VaR?

1. Increases Credit VaR significantly

2. Reduces Credit VaR as granularity increases

3. No effect in any scenario

4. Granularity only affects the Credit VaR at high default probabilities

The correct answer is: Reduces Credit VaR as granularity increases

The correct answer highlights that as portfolio granularity increases, Credit Value at Risk (VaR) tends to decrease. This is because a more granular portfolio is diversified across a larger number of individual exposures. This diversification reduces the impact of any single default on the overall portfolio, thereby leading to lower potential losses in adverse scenarios. In a more granular portfolio, the idiosyncratic risk associated with individual credit exposures is mitigated. This means that even if one or a few credits in the portfolio default, the overall effect on the portfolio's risk profile is less severe compared to a concentrated portfolio, where a few large exposures could dominate the risk profile. The other choices do not hold true in this context. Increasing Credit VaR significantly would imply that the portfolio is more concentrated rather than granular, which contradicts the principle of diversification. The assertion that there is no effect in any scenario overlooks the fundamental concept of risk management where diversification plays a crucial role in mitigating risk. Lastly, the idea that granularity affects Credit VaR solely at high default probabilities does not accurately capture the comprehensive nature of how portfolio diversification consistently influences risk across various scenarios, not just under extreme conditions.