Question

a) Briefly discuss the problems associated with using modern portfolio theory for measuring a FI’s aggregate credit risk exposure.

b) Consider the coefficients of Altman’s Z-score. Comment on the size of the coefficients and explain which ratios appear to be the most important in assessing the creditworthiness of a loan applicant. Also, comment upon the key limitation of this method.

Answer 1

a) Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. According to the theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the maximum possible expected return for a given level of risk. This theory was pioneered by Harry Markowitz in his paper "Portfolio Selection," published in 1952 by the Journal of Finance. He was later awarded a Nobel prize for developing the MPT.

THE PROBLEMS OF USING MODERN PORTFOLIO THEORY

Critics contend MPT doesn't deal with the real world, because all the measures used by MPT are based on projected values, or mathematical statements about what is expected rather than real or existing. Investors have to use predictions based on historical measurements of asset returns and volatility in the equations, which means they are subject to be changed by variables currently not known or considered at the time of the equation.

Investors have to estimate from past market data because MPT tries to model risk in terms of the likelihood of losses, without a rationale for why those losses could occur. That makes the risk assessment probabilistic, but not structural.

In simple words, the mathematical model of MPT makes investing appear orderly when its reality is far less so.

b)The Altman Z-score is a combination of five financial ratios weighted by coefficients that is used to estimate the likelihood of financial distress.The coefficients were estimated by identifying a set of firms which had declared bankruptcy and then collecting a matched sample of firms which had survived, with matching by industry and approximate size (assets).

The original Altman Z-Sore was developed for US manufacturing companies and the formula is was as follows:

X1 = Working Capital (Current Assets less Liabilities) / Total Assets. Measures liquid assets in relation to the size of the company.

X2 = Retained Earnings / Total Assets. Measures profitability that reflects the company's age and earning power.

X3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency apart from tax and leveraging factors. It recognizes operating earnings as being important to long-term viability.

X4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that can show up security price fluctuation as a possible red flag.

X5 = Sales / Total Assets. Standard measure for total asset turnover (varies greatly from industry to industry).

The five variables are then weighted together according to the following formula:

Altman Z-Score = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5.

A Z-Score above 2.99 suggests that a company is in the Safe Zone based on the financial figures only. A Z-Score between 1.8 and 2.99 is in the Grey Zone which suggests there is a good chance of the company going bankrupt within the next two years of operations. Meanwhile, a Z-Score below 1.80 is in the Distress Zone which indicates a high probability of distress within this time period.