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Explanation:
Unexpected Loss (UL) acts as a standard deviation for credit losses. Standard deviations (and therefore unexpected losses) cannot simply be summed up to find the portfolio's total risk unless the individual assets are perfectly positively correlated (). Since assets in a portfolio typically have correlations less than 1, simply aggregating individual unexpected losses would ignore diversification benefits and overstate the portfolio's actual unexpected loss.
Q.50 While performing a risk analysis on a corporate bond portfolio, a financial analyst calculates the expected loss for each bond. To better assess the bank's resilience to credit risk, the analyst must now estimate the unexpected losses. The bonds have varying probabilities of default and loss given defaults, with associated volatilities. Why can't the analyst simply aggregate the unexpected losses of individual bonds to estimate the total unexpected loss for the portfolio?
A
Because the unexpected loss is calculated using the average of the expected losses, and the aggregation of the averages does not give the unexpected loss.
B
Because the aggregation of individual unexpected losses assumes perfect correlation among the bonds, which is rarely the case in practice.
C
Because the bond portfolio is subject to market risk, which needs to be calculated separately from the credit risk of individual bonds.
D
Because the unexpected loss calculation requires the inclusion of recovery rates, which have not been accounted for individually for each bond.
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