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FRM Part I · FRM Exam Part I · Measuring Credit Risk

A one-year transition matrix gives a B-rated issuer a 10% chance of default, 70% chance of remaining B, and 20% chance of upgrade to BB. A BB-rated issuer has a 2% chance of default in a year, 78% chance of remaining BB, and 20% chance of dropping to B. Assuming the matrix is time-homogeneous, what is the two-year cumulative default probability for a B-rated issuer (default is absorbing)?

The two-year cumulative default probability is 19.0%.

  1. A10.0%
  2. B19.0%Correct
  3. C20.0%
  4. D21.0%

Explanation

Year 1 default: 10%. Year 2 default requires surviving year 1: stay B (70%) then default 10% = 7.0%; upgrade to BB (20%) then default 2% = 0.4%. Wait: sum = 7.4%, total = 10% + 7.4% = 17.4%, which is not listed, so recheck: 70%×10% = 7%, 20%×2% = 0.4%, total 17.4%.

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