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FRM Part I · FRM Exam Part I · External and Internal Credit Ratings

A portfolio manager observes that bonds rated BBB by an agency have historically shown very different default rates in recessions than in expansions, even though the rating label is unchanged. This observation primarily reflects which feature of agency ratings?

This reflects the through-the-cycle nature of agency ratings. Because grades are meant to stay stable across the economic cycle, the realized default rate for a given rating such as BBB rises in recessions and falls in expansions, making the grade an imperfect fixed measure of default probability.

  1. ARatings are point-in-time and recalibrated every month to the business cycle
  2. BRatings are through-the-cycle, so default probabilities associated with a grade vary with the economic cycleCorrect
  3. CRatings are based solely on equity market volatility
  4. DRatings are always identical across agencies, so cycles do not matter

Explanation

Through-the-cycle ratings aim to be stable across the cycle, so the realized default frequency for a given grade rises in downturns and falls in booms. A point-in-time system would instead migrate ratings with the cycle, keeping default rates per grade more stable.

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