Diversity Score

What Is a Diversity Score?

The diversity score is a proprietary instrument developed by Moody's Investors Service that estimates the level of diversification in a portfolio containing alternative assets. Specifically, it was initially made to check the relative risk of specific collateralized debt obligations (CDOs).

As the mortgage CDO market expanded in the mid 2000s, be that as it may, Moody's could never again keep on trusting the scoring algorithm thus the diversity score was modified under the heading of its credit committee.

Diversity Scores Explained

The Moody's Diversity Score measures the number of uncorrelated assets that would have similar loss distribution as the real portfolio of related assets. For instance, in the event that a portfolio of 100 assets had a diversification score of 50, this means the 100 assets held would just have similar loss distribution as 50 uncorrelated assets. Assets in a similar industry or from a similar issuer are thought of as indistinguishable, and an individual default risk is assigned to every asset in the portfolio. Of course, working out the specific value is a bit more nuanced.

During the 2000s, Moody's seen that most CDOs at the time contained RMBS assets and thus needed diversity, so it presently not checked out to utilize the diversity score. By leaving the score, nonetheless, Moody's gotten fire from regulators and the investment community for fairly uplifting the unsafe way of behaving that prompted the subsequent housing market crash and credit bubble.

Today, the diversity score is utilized to survey the conditions of different assets like collateralized advance obligations (CLO). Hypothetically, CLOs with a high diversity score are safeguarded from the promising and less promising times of the market in light of the fact that not everything in that frame of mind of loans is presented to similar conditions. This means the probability of the whole portfolio floundering is more modest than if it exhibited a high correlation.

Changes Made to the 'Diversity Score'

In 2009 following the burst of the CDO bubble and the subsequent financial crisis, Moody's rolled out critical improvements to its calculation of the diversity score. Greater complexity and relationship of the credit markets put a tremendous burden on numerous locales, industries and economies around the world. Each factor prompted a sharp increase in noticed default correlation among corporate credit, which pushed Moody's to make a more reasonable score that mirrored the changing market environment. The new methodology refreshed a few key boundaries of the existing model used to rate and monitor CLOs.

Limitations of the Diversity Score

A few analysts guarantee the diversity score is an imperfect measure of risk. It doesn't consider how industries inside a portfolio pool might be linked. For instance, a CLO comprising of loans to a shipping group and petroleum producer is viewed as very much differentiated, however in reality, the price of gas likewise influences the shipping industry. Others propose that the score overestimates default probabilities and correlation and doesn't give sufficient weight to recovery rates after default.

Highlights

• As correlations between CDOs in the marketplace developed, the scoring algorithm must be modified, with its 2009 modification bringing about far greater complexity and subtlety following the 2008 financial crisis.
• Moody's Diversity Score is a measure to estimate the diversification in a portfolio that thinks about the issuer and industry focuses in the genuine portfolio and incorporates suppositions on default correlations.
• The Diversity Score is gotten from the CDO's month to month surveillance reports, measuring the number of uncorrelated and indistinguishable assets that would have a comparative loss distribution the genuine portfolio of related assets.