Answer: The unexpected loss of the portfolio will increase.

## 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.

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