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

A bank's internal rating system has five grades. Over one year, the transition matrix shows that of 200 obligors starting in grade 3, 10 moved to grade 2, 150 stayed in grade 3, 30 moved to grade 4, and 10 defaulted. A risk manager says grade 3's one-year probability of downgrade (including default) is 20%, and that migration to a better grade is 5%. Which assessment is correct?

Both statements are correct. Downgrades plus default total 40 of 200 obligors, or 20%, and upgrades are 10 of 200, or 5%. The remaining 150 stayed, giving 75%, so the probabilities sum to 100%.

  1. ABoth statements are correctCorrect
  2. BThe downgrade probability is 15% and the upgrade probability is 5%
  3. CThe downgrade probability is 20% but the upgrade probability is 10%
  4. DThe downgrade probability is 25% and the upgrade probability is 5%

Explanation

Downgrades including default: 30 + 10 = 40 out of 200 = 20%. Upgrades: 10/200 = 5%. Stayers are 150/200 = 75%, and 75+20+5 = 100%. Excluding default would give 15%, which is the key mistake in the second option.

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