Credit Risk Management Practice Exam

What is a significant drawback of using the correlation-based credit portfolio framework?

1. Underestimates potential losses

2. Requires a large number of calculations

3. Ignores default probability

4. Overestimates credit quality

The correct answer is: Requires a large number of calculations

The choice indicating that a significant drawback of using the correlation-based credit portfolio framework lies in its requirement for a large number of calculations is valid because such frameworks often rely on modeling the correlations between various credit risks across different entities. This means that to accurately assess the risks in a diversified credit portfolio, an extensive number of interdependencies must be evaluated. This complexity arises from the need to establish the relationships between default events of different obligors, which can quickly increase the computational burden on risk management systems. As a result, while the framework can provide insights into credit portfolio dynamics, its reliance on extensive calculations can lead to operational challenges and resource constraints, making it less efficient in practice. The mention of requiring a large number of calculations highlights the practical implications of using this framework for financial institutions, as diligent risk assessment often necessitates advanced computational power and sophisticated modeling techniques, which can be demanding in terms of time and resources.