FRM Part II · FRM Exam Part II · Estimating Default Probabilities
A bank's portfolio contains 200 loans rated BB at the start of the year. Over the year, 150 remain BB, 20 are upgraded to BBB, 18 are downgraded to B, and 12 default. Using the cohort approach, what is the estimated one-year probability of a BB loan being downgraded to B?
The cohort estimate is the number of BB loans that moved to B divided by the starting number of BB loans, 18 divided by 200, which equals 9.0%. The counts reconcile to 200 loans, and the upgrade and default figures are different transitions.
- A9.0%Correct
- B12.0%
- C10.0%
- D7.5%
Explanation
Cohort estimate = number moving from BB to B divided by number of BB at start = 18/200 = 9.0%. Using 12 gives the default probability (6%), not downgrade; 20/200 = 10% is the upgrade rate. Check: 150+20+18+12 = 200.
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