medium · FRM Part 2 Market Risk

If a risk system models joint defaults using a Gaussian copula calibrated during a period of low volatility, why is it likely to understate the risk of a senior CDO tranche?

1. The Gaussian copula underweights idiosyncratic defaults relative to systematic ones.
2. Gaussian copulas assume fat-tailed marginal distributions, overstating joint default risk.
3. The Gaussian copula lacks tail dependence, failing to capture clustered defaults in crises.
4. Gaussian copulas apply only to equities and cannot be calibrated to credit spreads at all.

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