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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A analyst estimates transition probabilities using the cohort approach versus the duration (hazard rate) approach. Which statement is correct?

The cohort approach looks only at ratings at the start and end of each period, so it ignores intra-year movements and can estimate zero for rare transitions. The duration approach uses time in each rating and avoids this.

  1. AThe cohort approach uses only start- and end-of-year ratings, ignoring intra-year migrations, and so can assign zero probability to rare transitionsCorrect
  2. BThe duration approach ignores time spent in each rating and uses only year-end ratings
  3. CThe cohort approach produces a generator matrix with continuous-time intensities
  4. DThe duration approach cannot estimate transitions that were never observed

Explanation

The cohort approach counts only beginning- and end-of-period ratings, so rare transitions observed only intra-year or not at all get zero probability. The duration approach uses time spent in each rating and can produce nonzero estimates for unobserved direct transitions via the generator matrix.

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