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

A credit analyst reviews a one-year rating transition matrix built from historical agency data. Which statement about the row for the default state (D) in such a matrix is correct?

Default is an absorbing state in a rating transition matrix, so the default row shows a 100% probability of remaining in default and zero probability of moving to any other rating. This reflects the modelling assumption that defaulted issuers do not recover to a rating class.

  1. ADefault is an absorbing state: the probability of staying in D is 100% and the probability of moving to any other rating is zeroCorrect
  2. BDefault is a transient state: defaulted issuers are upgraded to CCC with a small probability each year
  3. CThe default row shows the average default probability across all rating classes
  4. DThe default row is omitted because defaulted issuers are removed from the matrix and cannot be tracked

Explanation

In a standard transition matrix, default is treated as an absorbing state. Once an issuer defaults, it stays in D with probability 1 and cannot migrate to other ratings. The other options misdescribe the row's meaning.

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