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FRM Part II · FRM Exam Part II · Credit Value at Risk

A bank uses a ratings-based migration model for a portfolio of loans. Which is a recognized limitation of using a historical through-the-cycle transition matrix for credit VaR?

A historical through-the-cycle transition matrix assumes stable migration probabilities, so it may not reflect the current phase of the credit cycle or rating momentum. This can misstate near-term migration and default risk and hence credit VaR.

  1. AIt captures current economic conditions precisely, causing excessive volatility in VaR
  2. BIt assumes migration probabilities are stable and may not reflect the current point in the credit cycle or rating momentumCorrect
  3. CIt cannot be used for any portfolio with more than one obligor
  4. DIt requires equity prices for every obligor

Explanation

Historical average matrices assume stationarity and often independence from the cycle, so they can misstate near-term migration and default probabilities in booms or recessions. They do not need equity prices, and they can be applied to portfolios. Through-the-cycle matrices are smoother, not highly responsive.

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