A bank credit officer, who has reviewed a loan application, has made the following statement: "On a standalone basis, I was not very keen on granting this loan however, I granted this loan after looking at the overall asset portfolio of the bank." Based on the above statement, which of the following is true.
A. The correlation of the newly granted loan with the overall portfolio is low and therefore the credit officer was right in granting the loan.
B. The correlation of the newly granted loan with the overall portfolio is low and therefore the credit officer was wrong in granting the loan.
C. The correlation of the newly granted loan with the overall portfolio is high and therefore the credit officer was right in granting the loan.
D. The correlation of the newly granted loan with the overall portfolio is high and therefore the credit officer was wrong in granting the loan.
Answer:A
The risk of a loan at the portfolio level is guided by both its systematic risk and unsystematic risk. Therefore low Correlation of the new loan with the overall existing portfolio make it better investment decision due to diversifications benefits. Therefore, the credit official was right in his reasoning.

 

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