Portfolio Theory and Banks

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Portfolio Theory and Banks

Over the years competition in the financial industry has been very high. Banks have been competing harder over market shares and profits. These firms have of late been facing a very unique challenge; how to extract high levels of profit while still maintaining their foundations as lending institutions. Lending is not a very profitable business, the risk of default coupled with the competition driving down market prices have made lending a less attractive enterprise. Therefore some banks are trying to concentrate on their more profitable activities (i.e. advisories, debt and equity sales, mergers and acquisitions). But to be able to extract this sort of business requires banks to engage in loans. Without loans customers have no incentive to do business with them, since one of their primary needs is to finance their commercial activities through debt. Portfolio theory gives these lending institutions a tool to minimize the risks and hazards of lending.

Portfolio theory was first published by Fischer Black and Myron Scholes in 1973. This model provided banks with a strategy on how to diversify their loans and investments. Before this, banks had no real investment strategy and their only option was to obtain as much collateral as possible and make default an unattractive option. Portfolio Theory allows companies or investors to diversify their investment so to minimize risk and maximize gain. The principle behind the Black – Scholes model is to diversify your equity so that your lowest risk bond produces the same risk as your highest risk investment. When your investments have reached this equilibrium, then risk minimization has been achieved.[1]

[1] www.kmv.com/Knowledge_Base/public/general/white

/Portfolio_Management_of_default_Risk.pdf

What is the Black - Scholes model? The model also called portfolio theory works under the following assumptions: 1) Price of the underlier is lognormally distributed 2) No transaction costs 3) Markets trade continuously 4) Risk-free rate is constant and the same for all maturities.[1] The model was first used for simple put and call options and now has been expanded for use with other financial instruments. This model is a mathematical model and certain variables are needed for the formula to work. These variables are the stock price, exercise price, time to maturity, volatility, and price of a discount bond that matures when the option does.

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