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

A bank's risk committee notes that a corporate issuer's external rating changed only after the issuer's bond spreads had already widened sharply over several months. Which limitation of external ratings does this observation most directly illustrate?

The observation shows that external ratings lag market information. Agencies use a through-the-cycle approach that favors rating stability, so changes come slowly and often after bond spreads have already moved. Ratings are therefore not very timely indicators of credit deterioration compared with market-based measures.

  1. ARatings are issued only for sovereign borrowers and ignore corporates
  2. BRatings are slow to reflect new information because agencies aim for stability, so they lag market pricesCorrect
  3. CRatings are recalculated daily and therefore are too volatile for risk management
  4. DRatings measure only liquidity risk and ignore default risk

Explanation

Agencies rate through the cycle and avoid frequent changes, so rating actions often trail market-based signals such as credit spreads. The volatility option is wrong because ratings are deliberately smoothed, not recalculated daily.

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