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FRM Part II · FRM Exam Part II · Credit Risk Management

A bank observes that, in its annual transition matrix, the probability of an A-rated obligor being downgraded is much higher in recessions than in expansions. This pattern most directly indicates which limitation of using a single average transition matrix?

Migration depends on the business cycle, so the assumption that one transition matrix applies every year (time-homogeneous Markov) is questionable. A single average matrix would understate downgrade and default risk in recessions and overstate it in expansions.

  1. AMigration is not independent of the business cycle, so the Markov time-homogeneity assumption is questionableCorrect
  2. BDefault probabilities of investment grade obligors are always zero
  3. CRatings cannot be mapped to default probabilities
  4. DTransition matrices cannot include an absorbing default state

Explanation

Cycle-dependent migration means probabilities vary over time, violating time-homogeneity. A single average matrix then understates recession risk. The other statements are false.

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