The concentration ratio is a measure of the degree to which a creditor's portfolio is diversified. A lower concentration ratio indicates a higher level of diversification. Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. The rationale behind this technique is that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Therefore, the lower the concentration ratio, the higher the diversification, and consequently, the lower the default risk of the creditor. This is because a diversified portfolio is less likely to be severely affected by the failure of any single investment. Hence, a lower concentration ratio is desirable for a creditor as it reduces the risk of default.

Choice B is incorrect. A higher concentration ratio does not imply higher diversification. In fact, it's the opposite. A high concentration ratio indicates a high level of exposure to a particular asset or group of assets, which reduces diversification and increases default risk.

Choice C is incorrect. This statement incorrectly associates a lower concentration ratio with lower diversification and higher default risk. In reality, a lower concentration ratio signifies greater diversification and thus lowers the default risk for the creditor.

Choice D is incorrect. Similar to choice B, this option incorrectly suggests that a higher concentration ratio leads to increased diversification and default risk simultaneously. However, an increase in the concentration ratio actually decreases diversification while increasing default risk.

Things to Remember

• Concentration risk is the risk of loss associated with a single asset or a small group of assets dominating a portfolio.
• Diversification is a risk management technique that involves spreading investments across different assets to reduce exposure to any single asset.