FRM Part II · FRM Exam Part II · Credit Scoring and Rating
A fund's investment policy permits only securities rated investment grade by a major agency. After a bond is cut to just below investment grade, many funds with similar mandates are forced to sell at once, and the price falls sharply. Which limitation of reliance on ratings does this illustrate?
This illustrates cliff effects. Mechanical rating thresholds in mandates cause many investors to sell simultaneously when a bond crosses from investment grade to speculative grade, producing herding and amplified price declines. It is not rating inflation or a granularity problem, since the issue is the hard threshold itself.
- ACliff effects from rating-based thresholds that create herding and forced sellingCorrect
- BRating inflation for senior tranches
- CInsufficient granularity of the rating scale at the top end
- DRatings being based solely on equity market prices
Explanation
Hard rating thresholds in mandates and regulations create cliff effects: a one-notch move across the boundary triggers mass forced selling. This amplifies price moves and herding, a recognised drawback of mechanical reliance on ratings. The scenario says nothing about inflated tranche ratings.
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