foundation

anbu.edu
Finance Junkie
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Joined: Mon Feb 04, 2013 3:35 pm

foundation

Postby anbu.edu » Wed Oct 09, 2013 2:40 am

You are hired as the credit risk manager for a large bank. You find that the bank’s credits are poorly diversified. The bank has an extremely large exposure to one firm with a BB rating. All its other loans have the equivalent of an AAA rating. You recommend that the bank diversify its credit exposures. After the bank follows your advice, you are summoned to the CEO’s office and fired. The CEO says that they followed your advice, acquired many small exposures to firms with BB ratings to replace the large exposure, and all it did was to make the bank riskier because its credit VaR increased. The bank measures its credit VaR as the maximum loss of principal over one year at the 1% level. You seek advice from a consultant to make sure not to repeat the mistake you made. Which of the following explanations provided by the consultant is correct?
Choose one answer.
Choose one answer.
a. VaR necessarily falls as diversification increases. Consequently, the bank’s software to compute VaR must be flawed. Incorrect
b. The VaR would not have increased had the bank measured it as a shortfall relative to the expected value of the banking book. Correct
c. The bank did not diversify since it replaced one exposure with a BB rating with multiple exposures with a BB rating. Incorrect
d. The VaR would not have increased had the bank not used the normal distribution for the portfolio return. Incorrect
The correct answer is The VaR would not have increased had the bank measured it as a shortfall relative to the expected value of the banking book.


Can anyone explain the answer little more clearly

pradeeppdy
Finance Junkie
Posts: 258
Joined: Thu Sep 20, 2012 3:42 pm

foundation

Postby pradeeppdy » Thu Oct 10, 2013 8:34 am

By diversifying, the bank swaps the small probability of a large loss for the certainty of a
small loss. Yet, the expected value of the banking book is unchanged and the volatility of the terminal
value of the banking book has fallen.


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