Financial Correlation Modeling – Bottom-Up Approaches (FRM Part 2 2025 – Book 1 – Chapter 9)

Master Financial Correlation Modeling for FRM Part 2 – Book 1 (Market Risk Measurement & Management). This lesson demystifies the bottom-up approach using the Gaussian copula, from mapping unknown marginal distributions to the standard normal, to estimating joint default probabilities and scaling to multi-asset portfolios with a correlation matrix. Clear analogies + a worked bond-default example.

You’ll learn to:
Explain copulas and why correlation alone can mislead
Map unknown distributions → standard normal (Sklar’s theorem idea)
Estimate joint default probability for two bonds
Extend to n assets, CDS/CDO applications, and Monte Carlo intuition

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After completing this reading you should be able to:
Explain the purpose of copula functions and the translation of the copula equation.
Describe the Gaussian copula and explain how to use it to derive the joint probability of default of two assets.
Summarize the process of finding the default time of an asset correlated to all other assets in a portfolio using the Gaussian copula.

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