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FRM Part II · FRM Exam Part II · Introduction to Credit Risk Modeling and Assessment

A portfolio manager notes that rating transition probabilities estimated from historical data show momentum: issuers recently downgraded are more likely to be downgraded again than the Markov assumption implies. What is the main implication for credit risk models using a standard transition matrix?

Rating momentum violates the Markov assumption. Because recently downgraded issuers are more likely to fall again, a model that compounds a single matrix will tend to understate multi-period downgrade and default risk.

  1. AMulti-period downgrade and default risk will tend to be understatedCorrect
  2. BMulti-period default risk will tend to be overstated
  3. COne-year default probabilities become unobservable
  4. DThe matrix rows no longer sum to one

Explanation

The Markov assumption says the next move depends only on the current rating. If past downgrades raise the chance of further downgrades, a matrix powered forward misses this serial dependence, so multi-period deterioration and default are understated.

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