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FRM Part II · FRM Exam Part II · Credit Risk Management

A portfolio manager notes that rating agencies' ratings exhibit 'rating momentum', where a firm downgraded in one period is more likely to be downgraded again. Which statement about the implication for modelling with a standard Markov transition matrix is correct?

Rating momentum violates the Markov assumption because future migration depends on past rating changes, not only the current rating. Multi-year default probabilities obtained by raising the matrix to a power may therefore be understated for recently downgraded firms.

  1. AMomentum is consistent with the Markov assumption because future migration depends only on the current rating
  2. BMomentum violates the Markov assumption, so multi-year default probabilities from a matrix power may be understated for recently downgraded firmsCorrect
  3. CMomentum implies the matrix rows no longer sum to one
  4. DMomentum makes default a non-absorbing state

Explanation

Markov models assume next-period migration depends only on the current rating, not on the path. Momentum shows history matters, so matrix powers can understate further downgrade and default risk for recently downgraded names.

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