Credit Risk Management Practice Exam

In linear discriminant analysis, what does the Z-score signify?

1. A measure of creditworthiness

2. A point for loan approval

3. A threshold for bankruptcy

4. A metric for operational risk

The correct answer is: A measure of creditworthiness

In the context of linear discriminant analysis (LDA), the Z-score serves as an important statistical measure that reflects how an individual or a case compares to a standard or average within a specific population. Specifically, it quantifies the number of standard deviations a data point is from the mean. When applying LDA, which is often used in credit risk management to classify credit risk scores, the Z-score can be utilized to assess the creditworthiness of borrowers. A higher Z-score indicates that a borrower is considered more creditworthy, as it shows that their financial metrics are significantly better than the average. Conversely, a lower Z-score suggests a higher risk of default. This measure helps financial institutions make informed decisions about lending, as it provides a standardized method to evaluate the likelihood of a borrower meeting their debt obligations based on available financial data. The context of the other options does not align with this specific role of the Z-score within the framework of linear discriminant analysis, affirming that it is primarily used as an indicator of creditworthiness among various potential metrics and thresholds within financial risk assessment.