hard · FRM Part 2 Market Risk
A desk is using a Gaussian copula to model the joint default of two high-yield issuers. During a market crisis, the realized joint defaults far exceed the model's predictions. The desk head proposes increasing the correlation parameter ρ from 0.3 to 0.7 to fix the model.
What is the structural flaw in this proposal?
- The proposal fails because the correlation between high-yield issuers is mean-reverting and will likely fall after the crisis.
- Raising the correlation parameter increases the risk of the equity tranche but does not address tail dependence.
- The Gaussian copula assumes marginals are normal, which is the primary cause of the joint default underestimation.
- Increasing correlation will decrease the probability of joint default, making the model even less conservative.
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