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

A bank's validation report finds that realized default rates for its investment-grade buckets were consistently below predicted PDs during a long economic expansion, while PDs had been calibrated to a through-the-cycle approach. Which interpretation is most appropriate?

Realized defaults below predicted PDs are expected in an expansion when PDs are calibrated through the cycle, because those PDs reflect average conditions. The result should be assessed over a full cycle rather than prompting immediate cuts or model rejection.

  1. AUnderprediction of defaults is not indicated; the overestimate is consistent with through-the-cycle PDs exceeding point-in-time rates in benign conditions, so results should be judged over a full cycleCorrect
  2. BThe rating model must be discarded because any deviation signals zero discriminatory power
  3. CThe bank should lower all PDs immediately to the realized rates, as through-the-cycle ratings should track current conditions
  4. DThe result proves the defaults are positively correlated, so the binomial test is too lenient

Explanation

Through-the-cycle PDs reflect average conditions, so in expansions realized defaults tend to be below them and in downturns above. Backtests should be assessed over a full cycle, and the deviation does not imply poor discrimination. Immediately re-marking contradicts the TTC design.

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