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FRM Part II · FRM Exam Part II · Credit Value at Risk

A risk analyst is describing the CreditMetrics approach to measuring the credit VaR of a single bond. Which statement best describes how CreditMetrics defines the horizon value distribution?

CreditMetrics builds the horizon value distribution from rating transition probabilities: the bond is revalued in each possible end-of-horizon rating, using forward spreads or recovery if default, and those values are weighted by migration probabilities. It is a migration-based, mark-to-model approach, not a default-only or historical price approach.

  1. AIt simulates the firm's asset value path until default and records the recovery at the default date only
  2. BIt uses the bond's rating migration probabilities over the horizon, revalues the bond in each end-of-horizon rating state, and weights the values by transition probabilitiesCorrect
  3. CIt fits a normal distribution to historical daily bond price changes and scales to the horizon by the square root of time
  4. DIt uses only the default and no-default states, ignoring upgrades and downgrades

Explanation

CreditMetrics takes a transition matrix, assigns each possible end-of-horizon rating a revalued bond price (using forward credit spreads, or recovery for default), and weights by migration probability. This gives a discrete distribution of values. Default-only models ignore migration, and the other options describe structural or historical-VaR approaches.

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