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

A bank's internal rating system is described as 'through-the-cycle' (TTC). Which of the following best describes the expected behavior of its ratings and the associated probabilities of default (PDs) over an economic cycle?

A through-the-cycle system gives stable ratings because it looks at borrower quality over the full cycle, often under stress. Since grades barely react to current conditions, the realized default rate within each grade moves with the cycle, rising in recessions and falling in expansions.

  1. ARatings change frequently with current conditions, so the portfolio's average PD is high in recessions and low in expansions
  2. BRatings are stable across the cycle because they reflect the borrower's expected condition under stressed conditions, so the portfolio's average realized default rate per grade varies over the cycleCorrect
  3. CRatings are re-estimated every month using market equity prices, so migration rates are high
  4. DRatings are stable and realized default rates per grade stay constant across the cycle

Explanation

A TTC system assesses borrowers over a full cycle, usually assuming stress conditions, so grades change little as conditions change. Because the grade is not updated for current conditions, realized default rates per grade rise in recessions and fall in expansions. Option A describes a point-in-time system, and option D wrongly implies realized rates are constant.

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