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FRM Part II · FRM Exam Part II · Credit Scoring and Rating

A risk manager compares cohort-based and duration (hazard-rate) based estimation of rating transition probabilities from the same historical data. Which statement is most accurate?

The cohort method looks only at beginning and end ratings, so rare transitions such as a top-rated issuer defaulting can be estimated as zero. The hazard-rate method uses the timing of all rating changes and can produce small positive probabilities for such events and for any horizon.

  1. AThe cohort method uses only the ratings at the start and end of each period, so it can assign zero probability to rare transitions that the hazard-rate method would estimate as positiveCorrect
  2. BThe cohort method uses the exact timing of every rating change within the year, unlike the hazard-rate method
  3. CThe hazard-rate method cannot produce transition probabilities for horizons other than one year
  4. DBoth methods always yield identical estimates when the sample is large

Explanation

The cohort approach counts issuers at the beginning and end of the period and ignores intra-period movements, so rare transitions (e.g., AAA to default) often come out as zero. The hazard-rate (generator) approach uses the timing of all migrations and can give small positive probabilities and any horizon via matrix exponentiation. The other statements reverse or overstate these properties.

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