Credit Risk Management Practice Exam

What impact do positive correlations between contracts have on netting benefits?

1. They increase netting benefits significantly

2. They result in no impact on netting benefits

3. They provide lower netting benefits

4. They create higher exposure risks

The correct answer is: They provide lower netting benefits

When contracts have positive correlations, this means that the value of one contract tends to move in tandem with the value of another. In the context of netting, which is a risk management process used to reduce the number of obligations that exist between parties, positive correlations can lead to lower netting benefits. This is because if contracts are positively correlated and one is likely to gain value at the same time the other is also gaining value, the overall risk exposure does not decrease as much as it might with negatively correlated or uncorrelated contracts. Higher netting benefits typically come from offsetting positions—where losses in one contract can be offset by gains in another, thereby reducing the total exposure. In contrast, when there is a strong positive correlation and both contracts perform similarly, the netting effect is diminished, resulting in lower netting benefits. Consequently, this can lead to increased overall risk rather than a reduction of it. This understanding highlights the importance of analyzing correlations between contracts as part of a broader credit risk management strategy.