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

The basic idea in modern portfolio theory is that by using the diversification strategy one can reduce risk without sacrificing returns. In other words, the average return per unit of risk (variance or beta) can be maximized by creating a well-diversified portfolio.

Risk factors in a loan portfolio vary by industries, geographies, maturity size, etc. The portfolio manager can ensure that his portfolio is well diversified between these categories. Unless the asset added to the portfolio is perfectly related to the portfolio, it results in at least some benefit from diversification. The best assets are those that have the least (ideally negative) correlation with the portfolio.

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

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Moodys Analytics is a wellknown provider of credit risk management solutions that help lenders and investors assess and manage credit risk in their loan portfolios Moodys Analytics uses a combination ... View the full answer