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

A risk analyst reviews a one-year rating transition matrix built from a bank's corporate loan book. The row for BBB-rated obligors shows 90% remain BBB, 4% upgrade to A, 3% downgrade to BB, 2% downgrade to B, and 1% default. Which statement best describes the default entry in this row?

The default entry is the one-year probability that a BBB obligor defaults, estimated from historical migration experience. It describes frequency over a single year only, not multi-year cumulative default, loss severity, or the probability of downgrade.

  1. AIt is the one-year probability that a BBB obligor defaults, estimated from historical migration dataCorrect
  2. BIt is the cumulative five-year default probability for BBB obligors
  3. CIt is the loss given default for BBB obligors
  4. DIt is the probability that a BBB obligor is downgraded at least one notch

Explanation

Each row of a one-year transition matrix gives probabilities of moving from the starting rating to every other rating, including default, over one year. The 1% default entry is therefore the one-year default probability. It is not cumulative, and it says nothing about severity (LGD). A downgrade probability would be 3%+2%+1%=6% including default.

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