Credit Risk Management Practice Exam

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Which analysis identifies similar groups of borrowers based on their characteristics?

Principal component analysis
Cluster analysis
Cash flow analysis
Regression analysis

The correct answer is: Cluster analysis

Cluster analysis is the correct choice because it is specifically designed to group a set of objects—in this case, borrowers—into clusters based on their shared characteristics. By grouping borrowers with similar attributes, such as credit scores, income levels, or debt-to-income ratios, financial institutions can better understand their risk profiles and tailor their lending strategies accordingly. This technique reveals patterns within the data, allowing for targeted risk assessment and management. Principal component analysis is primarily used for dimensionality reduction rather than grouping; it transforms data to identify the underlying variables that explain the most variance. Cash flow analysis focuses on assessing the cash inflows and outflows of an entity to determine its liquidity and financial stability, which does not involve grouping based on characteristics. Regression analysis aims to identify relationships between variables, often predicting outcomes based on independent variables rather than clustering similar entities.