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

A credit committee notes that a rating agency's corporate ratings rarely change during recessions and expansions, even though the agency's own default-probability estimates for the same firms move noticeably over the cycle. Which conclusion is most consistent with the agency's methodology?

The agency follows a through-the-cycle methodology. It smooths out temporary cyclical effects and changes ratings only when credit deterioration or improvement is judged persistent. Hence ratings stay stable while point-in-time default probability estimates move with the economic cycle.

  1. AThe agency uses a through-the-cycle philosophy, so ratings are smoothed and adjust only to changes viewed as persistentCorrect
  2. BThe agency uses a point-in-time philosophy, so ratings fully reflect current default probabilities
  3. CThe ratings are unreliable because a rating must equal the current one-year default probability
  4. DThe agency ignores qualitative factors and relies only on market prices

Explanation

Through-the-cycle methodology filters out temporary cyclical movements, producing stable ratings while point-in-time default probabilities fluctuate. Option B contradicts the observed stability. Ratings are not defined as equal to current one-year PDs, so C is wrong.

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