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FRM Part II · FRM Exam Part II · Credit Scoring and Rating

A bank's validation team reviews a rating system for a portfolio of structured finance tranches. Before the crisis, many AAA-rated tranches suffered severe losses, whereas AAA corporate bonds rarely did. Which is the most relevant limitation of ratings revealed?

The same letter rating can hide very different risk, because structured tranches are exposed to correlation, systematic risk and model uncertainty in a way corporate bonds are not. Ratings are therefore not directly comparable across asset classes, as AAA tranche losses showed.

  1. AThe same letter grade can represent very different risk profiles, such as higher correlation and model risk in structured products, so ratings are not comparable across asset classesCorrect
  2. BRatings for structured products incorporate no quantitative modelling
  3. CAAA ratings reflect liquidity risk only
  4. DCorporate AAA ratings are always based on market prices

Explanation

Structured tranches have systematic-risk concentration, sensitivity to correlation assumptions, and model risk, so their loss distributions differ sharply from corporate bonds with the same grade. The label masks distribution differences. Other options misstate how ratings work.

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