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

A credit analyst reviews a one-year rating transition matrix for corporate issuers. Which description best characterizes the row of the matrix corresponding to the default state?

The default row is an absorbing state: the probability of staying in default is 1 and all other transitions are 0. Once an issuer defaults it does not migrate back within the model, and every row of the matrix still sums to 1.

  1. AIt is an absorbing state, with a probability of 1 of remaining in default and 0 for all other transitionsCorrect
  2. BIt shows the probability of default migrating upward to investment grade at the same rate as downgrades
  3. CIt contains the average recovery rates for each starting rating
  4. DIt sums to less than 1 because defaulted issuers may be withdrawn

Explanation

In a standard transition matrix, default is treated as an absorbing state: once an issuer defaults it stays in default over the horizon. The row therefore has 1 on the default cell and 0 elsewhere. Recovery rates are not part of the matrix, and each row must sum to 1.

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