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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A bank uses a transition matrix to value a bond portfolio for credit VaR. Which input is needed, in addition to the transition probabilities, to convert a rating migration into a change in a bond's value?

The bank needs the credit spreads, or forward curves, for each destination rating plus a recovery assumption for default. These allow the bond to be revalued after each migration, and the transition probabilities then weight the resulting values to build the loss distribution.

  1. AThe credit spread or forward curve associated with each destination rating, plus a recovery value for defaultCorrect
  2. BThe equity beta of each issuer
  3. CThe bank's own funding spread only
  4. DThe issuer's accounting leverage in each rating class

Explanation

In a migration-based approach, the bond is revalued at the end of the horizon using the credit spread curve for the new rating; for default, a recovery value is used. Probabilities alone give likelihoods, not value changes.

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