Question

Discuss the relevance of a portfolio approach to credit risk management, given the fact that the banks and financial institutions themselves are borrowers with high levels of leverage.    (8) marks

Answer 1

Credit risk means the risk of losses due to inability of the borrower to pay back to the company. Credit risk management(CRM) thus helps in managing the amount of risk that a company can bear and thus the amount of risk that it should undertake.

The portfolio approach to CRM requires estimation of correlation between volatilities of loss rates between levels of individual loans.

There are two fundamental variants. One is based on statistical analysis of historical experience of occurrence of default and loss in the event of default. The second is based on representing a firm's debt holders as having sold a put on the value of the firm and using option theory to analyze the probabilities of default and loss in event of default.

This approach is effective because it does not unnecessarily pass through the stages of equity and asset returns. It utilizes the econometric modelling of default rates thus measuring differently for different industries and different countries. As these are taken directly from the dependent variable these are very relevant.