Explanation:
Default correlation refers to the extent to which the defaults of individual bonds within a portfolio are correlated. In a credit portfolio, bonds that are highly correlated tend to default together, increasing the overall risk of the portfolio.
Portfolio B, consisting of highly correlated bonds, is expected to have a higher level of risk compared to Portfolio A, which consists of uncorrelated bonds. This is because the default of one bond in Portfolio B is more likely to trigger defaults in other bonds in the portfolio, amplifying the overall loss potential.
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Q.5541 You are a risk manager tasked with assessing the impact of default correlation on a credit portfolio. You have two separate credit portfolios with the following characteristics:
Which portfolio is expected to have a higher level of risk in terms of default correlation?
A
Portfolio A, because uncorrelated bonds have less risk than highly correlated bonds.
B
Portfolio B, because highly correlated bonds have more risk than uncorrelated bonds.
C
Both portfolios have the same level of risk because default correlation has no impact on portfolio risk.
D
It is impossible to determine the impact of default correlation on portfolio risk without further information.