Explanation

When default correlation increases while keeping all other parameters constant:

Expected Loss (EL)

• Expected loss remains unchanged because it depends only on individual default probabilities and exposure amounts, not on correlation
• EL = Σ (PD_i × LGD_i × EAD_i)
• Since individual PDs, LGDs, and EADs are unchanged, EL stays the same

Unexpected Loss (UL)

• Unexpected loss increases because higher correlation means defaults are more likely to occur simultaneously
• UL represents the standard deviation of credit losses
• With higher correlation, the portfolio becomes more concentrated and less diversified
• The variance of portfolio losses increases as correlation increases
• This leads to higher tail risk and greater potential for extreme losses

Why D is Correct

• Options A and C are incorrect because expected loss doesn't change with correlation
• Option B is incorrect because unexpected loss increases, not decreases
• Option D correctly identifies that unexpected loss increases with higher default correlation

This is a fundamental concept in credit portfolio risk management where diversification benefits decrease as correlation increases, leading to higher unexpected losses.