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

A bank's internal grade B has a TTC one-year default probability of 2.0%. The bank's PIT model shows that, in the current expansion, grade B borrowers have an estimated PD of 1.2%. In a later downturn, PIT PD for grade B is expected to be 3.5%. Over a full cycle the average PIT PD is about 2.0%. Which conclusion is best supported?

The 2.0% through-the-cycle PD approximates the cycle-average default probability. Compared with the point-in-time PD of 1.2% in the expansion it overstates risk, and compared with 3.5% in the downturn it understates risk. The reversed claim confuses the direction of the differences.

  1. AThe TTC PD of 2.0% approximates the cycle-average PD, so it will overstate risk in the expansion and understate it in the downturnCorrect
  2. BThe TTC PD of 2.0% is wrong because it should equal the expansion PD of 1.2%
  3. CThe PIT PD is the cycle average and the TTC PD fluctuates with conditions
  4. DThe TTC PD of 2.0% will understate risk in the expansion and overstate it in the downturn

Explanation

TTC PD approximates the long-run average, 2.0%. In the expansion the current PD is 1.2%, so TTC (2.0%) overstates it; in the downturn the PD is 3.5%, so TTC understates it. The last option reverses the direction of these errors.

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