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

A portfolio manager notes that agency transition matrices estimated across the business cycle show that the probability of a BBB issuer being downgraded is much higher in recessions than in expansions. What is the main implication for using a single average through-the-cycle matrix to estimate portfolio credit risk in a recession?

A single average matrix will tend to understate downgrade and default risk during a recession. Transition probabilities depend on the economic cycle, and the time-homogeneous Markov assumption blends good and bad periods, so actual recession migrations are worse than the average implies.

  1. AIt will tend to overstate downgrade and default risk because averages include boom periods
  2. BIt will tend to understate downgrade and default risk because the Markov, time-homogeneous assumption ignores cycle dependenceCorrect
  3. CIt will have no effect because transition probabilities are independent of the cycle
  4. DIt will overstate default risk because the default row is not absorbing

Explanation

Transition probabilities vary with the economic cycle, and an average matrix blends expansions and recessions. In a recession actual migrations are worse than the average, so the average matrix understates risk. The overstating option has the direction wrong.

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