Explanation:
In a CLO with higher loan granularity, characterized by a larger number of smaller loans, the risk is more evenly distributed across a broader range of borrowers and sectors. This diversification reduces the impact of any single loan's performance on the overall portfolio, thereby lowering the probability of tail events where extreme losses might occur. It also reduces concentration risk, which is the risk associated with having a large exposure to a single borrower or a small group of borrowers.
A is incorrect because an increased number of loans in a CLO does not inherently increase systemic risk. Systemic risk is more related to broader market conditions and not just the number of loans in a portfolio.
B is incorrect as higher loan granularity typically enhances diversification benefits, which in turn reduces the probability of tail events.
D is incorrect because while managing a larger number of loans might affect operational complexity, it is not the primary risk profile effect compared to the benefits of enhanced diversification.
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Q.5529 Global Finance Bank (GFB) is assessing a new collateralized loan obligation (CLO) offering, focusing specifically on the concept of loan granularly. In this CLO, the underlying pool consists of a large number of small-to-medium-sized corporate loans. How does the higher loan granularity in the CLO affect its risk profile compared to a structure with lower granularity?
A
It increases the systemic risk due to a higher number of loans.
B
It reduces the diversification benefit, thus increasing the probability of tail events.
C
It enhances diversification, thereby reducing the probability of tail events and concentration risk.
D
It leads to higher operational costs due to the complexity of managing a larger number of loans.