Friday, March 20, 2009

portfolio management (4)

the key to understanding unexpected loss is to understand the correlation of assets in the portfolio. correlation arises through linkages ,usually indirect,which result in more than one lending defaulting together.A well-spread portfolio,such as one consisting of a large number of personal loans is likely to be less volatile than a narrow portfolio of property advances that have a high risk of defaulting together in recessionary conditions . Banks need to hold sufficient capital to cover the volatility in their loan portfolio. The greater the volatility ,the greater the capital need . This can be developed into the concept of achieving a risk-adjusted return ( to cover expected loss ) on risk-adjusted capital (to cover unexpected loss). Extra capital need produces a greater cost in relation to more volatile portfolios and this needs to be factored into pricing decisions.
portfolio management enables the optimization of risk and reward . A bank will want to maximize the returns to its shareholders for any given level of risk , or minimize the risk for whatever level of returns is available . Active management of the composition of the bank is loan portfolio is key ,Active management can entail directing business development efforts into acquiring different type of loan assets or taking a conscious effort to exit certain type of business . it can also encompass securitization of parts of the loan portfolio and the use of credit derivatives , for example ,to swap portfolios with other institutions .

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