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Chapter 12 - Credit Risk: Loan Portfolio and Concentration Risk Chapter Twelve Credit Risk: Loan Portfolio and Concentration Risk Chapter Outline Introduction Simple Models of Loan Concentration Risk Loan Portfolio Diversification and Modern Portfolio Theory Moodys KMV Portfolio Manager Model Partial Applications of Portfolio Theory Regulatory Models Summary Appendix 12A: CreditMetrics Appendix 12B: CreditRisk+ 12-1 Chapter 12 - Credit Risk: Loan Portfolio and Concentration Risk Solutions for End-of-Chapter Questions and Problems 1. How do loan portfolio risks differ from individual loan risks? Loan portfolio risks refer to the risks of a portfolio of loans as opposed to the risks of a single loan. Inherent in the distinction is the elimination of some of the borrower-specific risks of individual loans because of benefits from diversification. 2. What is migration analysis? How do FIs use it to measure credit risk concentration? What are its shortcomings? Migration analysis uses information from the market to determine the credit risk of an individual loan or sectoral loans. With this method, FI managers track credit ratings, such as S&P and Moodys ratings, of firms in particular sectors or ratings classes for unusual declines to determine whether firms in a particular sector are experiencing repayment problems. This information can be used to either curtail lending in that sector or to reduce maturity and/or increase interest rates. A problem with migration analysis is that the information may be too late, because ratings agencies usually downgrade issues only after the firm or industry has experienced a downturn. 3. What does loan concentration risk mean? Loan concentration risk refers to the extra risk borne by having too many loans concentrated with one firm, industry, or economic sector. To the extent that a portfolio of loans represents loans made to a diverse cross section of the economy, concentration risk is minimized. 4. A manager decides not to lend to any firm in sectors that generate losses in excess of 5 percent of capital. a. If the average historical losses in the automobile sector total 8 percent, what is the maximum loan a manager can lend to firms in this sector as a percentage of total capital? Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = .05 x 1/0.08 = 62.5 percent of capital is the maximum amount that can be lent to firms in the automobile sector. b. If the average historical losses in the mining sector total 15 percent, what is the maximum loan a manager can lend to firms in this sector as a percentage of total capital? Concentration limit = (Maximum loss as a percent of capital) x (1/Loss rate) = .05 x 1/0.15= 33.3 percent of capital is the maximum amount that can be lent to firms in the mining sector.... View Full Document

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