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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A risk analyst reviews a one-year rating transition matrix estimated from agency data. Which statement best describes the row for the default state in a standard transition matrix?

Default is an absorbing state in a standard transition matrix, so its row assigns probability 1 to remaining in default and 0 to every other rating. Rows must sum to one, and the matrix carries no recovery information.

  1. ADefault is an absorbing state, so its row has probability 1 on default and 0 elsewhereCorrect
  2. BDefault row shows the probabilities of upgrades to investment grade after restructuring
  3. CDefault row contains the average recovery rates for each prior rating
  4. DDefault row sums to less than 1 because defaulted firms leave the sample

Explanation

In a standard Markov transition matrix, default is treated as absorbing: once reached, the issuer stays there. The row therefore has 1 in the default column and 0 elsewhere. Rows still sum to 1, and the matrix contains no recovery information.

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