Skip to content

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

A risk analyst at a bank reviews a one-year rating transition matrix built from historical agency data. Which statement best describes how the default column and the default row of such a matrix are treated?

Default is treated as an absorbing state. The default column gives the one-year probability of migrating into default from each rating, while the default row is 100% default, because a defaulted borrower is assumed to remain defaulted within the matrix.

  1. ADefault is an absorbing state: the default column shows probabilities of migrating to default, and the default row shows 100% staying in defaultCorrect
  2. BDefault is a transient state: the default row shows borrowers returning to investment grade with equal probability
  3. CThe default column is excluded because default cannot be observed over a one-year horizon
  4. DThe default row shows the recovery rate for each rating class

Explanation

In a standard transition matrix, default is an absorbing state. Once a borrower defaults it stays there, so the default row has 100% in default. The default column gives each rating's one-year default probability. Treating default as transient or as recovery information misreads the matrix.

Did you get it right without looking?

One question tells you little. A timed set on Introduction to Credit Risk Modeling and Assessment shows your real accuracy, how long you take and where you lose marks.

Practise Introduction to Credit Risk Modeling and AssessmentFree diagnostic mock

More Introduction to Credit Risk Modeling and Assessment questions