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

A risk manager compares CreditMetrics with a KMV-type structural model for a corporate loan book. Which statement correctly describes a key difference in how the two approaches generate default and migration risk?

CreditMetrics uses rating transition matrices and historical migration frequencies, while KMV-type models are structural and derive expected default frequency from asset value, asset volatility and the default point. The other statements swap or misstate these input sources.

  1. ACreditMetrics uses rating transition matrices and historical migration frequencies, whereas KMV-type models derive expected default frequency from asset value, asset volatility and the default pointCorrect
  2. BCreditMetrics derives default probabilities from equity prices, whereas KMV-type models rely on average historical rating transitions
  3. CBoth approaches rely only on historical rating transition matrices and differ only in the recovery assumption
  4. DKMV-type models allow only default or no default and ignore asset volatility

Explanation

CreditMetrics is a rating-migration framework that uses transition matrices, while KMV-type models are structural and estimate distance to default from asset value, volatility and the default point. The second option reverses the two approaches. The other options misstate the inputs of the models.

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