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FRM Part I · FRM Exam Part I · External and Internal Credit Ratings

A bank validates its internal rating system by comparing, for each rating grade, the number of obligors that defaulted over the year with the default rate predicted at the start of the year. Which description best fits this exercise?

This is calibration backtesting. Comparing the default rate predicted for each grade with the realized default frequency tests whether the estimated probabilities of default are accurate in level, rather than whether the system merely ranks borrowers correctly or compares against external ratings.

  1. ACalibration backtesting, which checks whether predicted default probabilities match realized default frequenciesCorrect
  2. BDiscriminatory power testing, which checks whether the system ranks borrowers correctly without regard to the level of PDs
  3. CStress testing, which applies hypothetical adverse scenarios to the portfolio
  4. DBenchmarking, which compares the bank's grades with those of an external agency

Explanation

Comparing predicted PDs with realized default rates by grade tests the accuracy of the quantification, which is calibration. Discriminatory power concerns rank ordering, not PD levels. No external comparison or hypothetical scenario is involved.

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