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FRM Part II · FRM Exam Part II · Fundamentals of Credit Risk

A risk analyst at a bank uses an annual rating transition matrix built from agency data. Which statement best describes the information contained in the row for the rating category 'BB'?

A row of a transition matrix gives, for obligors starting the year at a given rating such as BB, the probabilities of ending the year in each rating category including default. Because it is conditioned on the starting rating, the row sums to 100 percent.

  1. AThe probabilities that a BB-rated obligor at the start of the year ends the year in each rating category, including default, summing to 100%Correct
  2. BThe probabilities that an obligor in each category at year-end was rated BB at the start of the year, summing to 100%
  3. CThe cumulative default rates of BB obligors over horizons of one to ten years
  4. DThe recovery rates on BB-rated bonds in each seniority class

Explanation

Each row of a transition matrix is conditioned on the starting rating and gives the distribution over ending ratings, including default as an absorbing state. Rows therefore sum to 100%. The second option reverses the conditioning, which is why its probabilities would be taken across columns rather than rows.

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