Question

Please answer question b

1a. Describe how modern portfolio theory can be applied to manage the credit risk of a loan portfolio.

The core idea in modern portfolio theory is that one can reduce risk without compromising on returns using the strategy of diversification. In other words, mean return per unit of risk (say, variance or beta) can be maximized by constructing a well diversified portfolio.

Since the risk factors in a loan portfolio are dependent upon sectors, geographies, term to maturity size etc. the portfolio manager can ensure that his / her portfolio is well diversified across these categories. As long as the asset being added to the portfolio isn't perfectly correlated to the portfolio, it results in at least some benefit of diversification. The best assets are the ones with the least (ideally negative) correlation with the portfolio.

b. Explain how Moody Analytics alters standard portfolio theory for managing the credit risk of a loan portfolio.

Answer 1

Modern portfolio allows investor to construct a portfolio of multiple assets to maximize returns for a given level of risk. Also, he/she can construct a portfolio with the lowest level of risk provided a desired level of expected target returns. Moody's analytics is able to produce forward-looking default probabilities using the company’s Expected Default Frequency(EDF) model, LGD (loss given default) and EL (expected loss) by combining financial statement with the information from equity markets to work out predictive measurements of standalone credit risk through modification of standard portfolio theory.