portfolio management (3)

Establishing the likely loss in a portfolio can also be used to price risk . Eash new loan has a potential loss built into it and this 'expected loss' can be derived from the calculation explained in this section . To make a satisfactory return , a lender needs to cover the expected loss in the portfolio-which is acost of lending- plus make an additional margen to satisfy shareholders .
Expected loss gives an average level of loss over an economic cycle. however ,in any individual year, actual losses can vary from the annual average . actual losses are likely to be cyclical ,with a disproportionate number of defaults occurring in periods of recession. The likelihood is that in most years the actual losses seen will be below the average projected by expected loss, with short periods with losses significantly above the average . Unexpected loss theory recognizes this and attempts to measure how actual losses will differ from average losses . It deals with volatility around the expected level of loss .Volatility produces greater risk; the greater the volatility in a portfolio,In an extreme scenario ,the risk is that losses at a particular point could be so great as to threaten the bank is solvency .