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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A bank's lending team notes that the Altman Z-score of a borrower has fallen steadily over three years from 3.4 to 2.2 without breaching the distress cutoff. Which is the most appropriate use of this information in credit monitoring?

The decline from the safe zone into the grey zone is an early warning of deteriorating credit quality, so the bank should review the exposure and covenants. Z-scores are useful as trend signals, and waiting for the distress cutoff would lose that value.

  1. AIgnore it, since the score remains above 1.81 and the firm is not in the distress zone
  2. BTreat it as an early warning of deteriorating credit quality and review the loan and its covenantsCorrect
  3. CConclude default is certain within one year
  4. DReplace the score with the firm's equity price as the sole indicator

Explanation

The score moved from the safe zone to the grey zone, indicating deteriorating financial health even though it has not reached distress. Scores are best used as trend indicators that trigger review, not as binary predictions. Waiting for the distress cutoff would forgo the early-warning value.

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