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FRM Part II · FRM Exam Part II · Credit Scoring and Rating

A bank validates its internal rating grade 4, which has an assigned PD of 2.0%. Over the past year, 500 obligors were in grade 4 at the start and 14 defaulted. Using a simple comparison of the observed default rate with the assigned PD, which conclusion is most appropriate?

The observed default rate is 14 divided by 500, or 2.8%, which is above the assigned 2.0% PD. This suggests the PD may be underestimated, so the bank should investigate further, using statistical testing, before concluding anything from one year of data.

  1. AThe observed default rate is 2.8%, above the 2.0% assigned PD, which suggests the PD may be underestimated and warrants investigationCorrect
  2. BThe observed default rate is 2.8%, below the 2.0% assigned PD, so the PD is conservative
  3. CThe observed default rate is 0.28%, far below the assigned PD, so the grade is overly conservative
  4. DThe observed default rate is 3.5%, so the PD is exactly validated

Explanation

Observed default rate = 14/500 = 2.8%. This exceeds the 2.0% assigned PD, a sign of possible underestimation. A single year is not conclusive, so a statistical test and further investigation are appropriate. The option claiming 2.8% is below 2.0% is numerically wrong.

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