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FRM Part II · FRM Exam Part II · Credit Value at Risk

A CreditMetrics user notes that the standard approach takes a single transition matrix and fixed spread curves. Which limitation is most directly implied by this design?

The key limitation is that historical average transition probabilities and fixed spreads ignore business-cycle variation. In recessions, downgrades and spreads rise more than average, so CreditMetrics based on a single matrix may understate credit risk when it matters most.

  1. ATransition probabilities and spreads are treated as constant through the cycle, so the model may understate risk in downturnsCorrect
  2. BThe model cannot value defaulted bonds
  3. CThe model requires equity prices of every issuer
  4. DThe model cannot produce a loss distribution

Explanation

Using one average transition matrix and static spreads ignores the dependence of migration and spreads on the economic cycle, so downturn risk can be understated. The model does handle default through recovery rates, does not need equity prices for the matrix, and produces a loss distribution.

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